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Friday, February 12, 2016

Have you been caught swimming naked?

"Only when the tide goes out do you discover who has been swimming naked" - Warren Buffett

What did Buffett really mean? During bull markets, almost all stocks - the good, the not-so-good and the downright rubbish - tend to move up. Everyone seems to be elated because the value of their portfolios are moving up with leaps and bounds.

So, you really won't know how resilient your portfolio is to a strong down turn. When selling becomes relentless - like it is happening in the market now - almost all stocks tend to lose ground. But the good lose less. The rubbish collapse in a heap.

Many small investors are in a panic. Panic affects rational decision making. The irrepressible urge is to exit at any price. That only adds to the selling pressure.

And so the cycle repeats. A bull market is followed by a bear market, which is followed by another bull market and then again a bear market. Investors buy stocks without proper analysis at high prices during bull markets, and then dump them at huge losses during bear market sell-offs.

Is there no respite from this cycle? The answer is: No, because it is the inherent nature of markets. What should small investors do?

The short answer is: Learn and practice. In other words, learn all you can about how the stock market works. Then enter gradually.

Not the other way around. Most small investors jump into the market first and then try to learn why they lost money. A typical query in one of the business TV channels today: "I bought 1000 shares of Suzlon at 25; now it is down to 13. Should I hold or sell?"

Smart investors learn to prepare a financial plan and an asset allocation plan before entering the market. But they are in a minority. Many have been in the market for years and fail to comprehend why their portfolios are not generating returns to beat inflation and bank fixed deposit rates.

A good financial plan and an asset allocation plan based on an investor's risk tolerance act as guides to investing in a systematic way for generating long term returns. It is a process that is methodical but boring. If you are having fun with your stock investments/trading, you are probably not making any money.

The two plans put your investment decisions almost on auto-pilot. Your monthly savings are invested regularly according to your plans. During bull periods, your equity component will become overweight. Once it goes beyond your pre-set limit, you automatically book partial profits and reinvest the proceeds in other asset classes like fixed income, gold, cash.

During bear market sell-offs, there will be no need to panic. Your equity component will become underweight, and the other asset classes in your portfolio will become proportionately overweight. Once your equity component falls below your pre-set limit, re-balance your portfolio by liquidating part of your fixed income, gold and cash holdings to buy equity.

It is not rocket science - but requires discipline and patience. If your motivation to enter the stock market is to make some quick profits so you can buy a Royal Enfield or the latest mobile phone from Apple, the result will be a hat-trick of no's: no Royal Enfield, no iPhone and no money.

So, dear investor, you really have two choices. You either learn from those who have long experience in the market, or you will learn by losing money. The ball is in your court.

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