Become a better investor by learning how to swim

There is an old English idiom: Birds of a feather flock together. But the stock market is populated by strange birds that care two hoots about English. They prefer to follow the laws of physics – particularly the one that states: likes repel and unlikes attract.

So we have a variety of investors who are polar opposites – bulls and bears, active investors and passive investors, long-term investors and short-term traders, growth investors and value investors, those who trade on margin money and those who invest their savings, investors who try to make money and investors who try to build wealth. And all these opposites get attracted to the same market place, and think that their ideas are the best!

But the two types of investors that really matter – and needless to say that they are also polar opposites – are those who know what they are doing and those who don’t. The old pros and the babes in the woods. The ‘smart money’ and retail. It is not a level playing field. The scales are heavily weighted in favour of those who know what they are doing.

It is a chicken and egg situation for the new investor. How can you learn to swim if you are afraid to get into the water? But if you jump in before learning to swim, you might drown. Is there a way out? Fortunately, there is.

I learned to swim by myself by thrashing around near the bank of a pond. A lot of water got inside my lungs, nose and ears – and it wasn’t a pleasant experience at all. But I persisted and learned to do the ‘dog paddle’.

Eventually, I had to seek help from an expert swimmer – to learn proper swimming strokes and breathing techniques. I am not a pro, but consider myself an expert swimmer. Still, I’m very wary of diving into a fast-flowing river or a rough sea – because I don’t have sufficient experience of swimming under those adverse conditions.

Will you jump into the sea without any fear if you find yourself facing a barrage of 10 feet high waves? If yes, will you also be able to fend off a shark attack? The stock market is like a rough sea. The sharks are the old pros out to feed on young fish like you. Why become some one’s dinner?

Start learning to swim at the shallow end of the pool by investing in a bank recurring deposit and an index fund. After you have built up a corpus, take the help of an expert swimmer to understand financial planning and asset allocation, fundamental analysis and technical analysis. Only then should you venture out to sea.

Strategies for buying and selling stocks and mutual funds – analysis of last week’s exercise (Part I)

Last week’s reader exercise was a prelude to introducing certain strategies that can enhance the returns from stock market and mutual funds investment – particularly when the market is in a prolonged sideways consolidation.

Before I get into the analysis part, a big THANK YOU to all of you who participated. Except for questions 2 and 4, the answers to the other questions varied widely – as should be expected from investors with different experience and risk tolerances.

The Sensex has been trading in a broad band of about 2700 points – between 15300 and 18000 for almost 10 months. During this period, individual stocks have either hit the skids, or made new highs, or gone nowhere. Should you try to jump from stock to stock as one slides and another climbs? That would make the brokers rich.

At such times, stock picking skills come to the fore. Identify good funds or fundamentally strong stocks that still leave a ‘Margin of Safety’ and buy a small quantity. Where will the cash come from? If you had booked profits earlier and not redeployed the cash, then you have no problems. What if you are fully invested?

This is one reason why I recommend quarterly dividend option in bank fixed deposits (FD) and dividend options in mutual funds. That goes against the tenet of growth through compounding. But an investing strategy has to be flexible to factor in market vagaries.

The cash inflow through dividends and interests has several advantages. In funds, it works as automatic profit booking during bull phases. The dividend can either be reinvested in the same fund, or in a different fund, or to buy shares.

The interest from a fixed deposit can be invested in a recurring deposit, or for buying NSC certificates from the Post Office (which are not subject to the fluctuations of bank interest rates), or for buying funds through the SIP method. The principal should get reinvested in another FD – for a shorter period if rates are low. (An exception to this ‘rule’ will be covered in Part II next week.)

Question your own logic at all times, and try to avoid the ‘always growth option’ or ‘always through SIP’ strategies of investing. Suppose the market corrects viciously down to 12500 in the next 2 months. Unlikely, but possible. A year of gains will disappear from the growth option. SIP over 2 months of lower NAVs will not lower the holding cost of the previous 10 months by much.

Regarding gold, this what Warren Buffet has said: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”

I haven’t felt the need to buy gold. But if I did, it would probably be a gold ETF or a gold fund. Much more convenient from storage and transaction points of view.

This post has already become too long, and I haven’t even covered questions 4, 5 and 6. Guess you will have to wait till next week for my analysis – because 4 and 5 are a little tricky, and will need some explaining.

In the meantime, nods (and applause) for Rsuvarna, Joe and Ganesh for logical answers. A hat tip to Eswar for his elaborate thought processes which helped in writing this post.

Those whose names didn’t get mentioned, please don’t feel disheartened or slighted. None of the answers were ‘right’ or ‘wrong’. I was looking for the logic behind the choices.

Should you invest in lump sum or gradually?

Some frequent investor questions I face go like this:

'I have some spare cash. Should I invest it gradually in SIP (Systematic Investment Plan) or in a lump sum?'

'I have recently booked some profits from my portfolio. What should I do with the cash?'

'The market has moved up so much. Should I keep my savings in a fixed deposit or in a liquid fund?'

The answer will be different for different investors. Why? Because no two investors have the same financial situation. Some have aged parents to take care of. Some have EMIs on their residential accommodation. Some are planning to get married. Others have young school-going children.

But if I had to give a single answer, it would be: 'Follow your asset allocation plan.' (If you don't know how to go about making an asset allocation plan, read Chapter 12: How to Reallocate your Assets in my FREE eBook.)

Once you have an asset allocation plan in place, it will be a lot easier to decide what to do with your spare cash. If your equity allocation is too high already, don't buy any more shares. Invest in fixed income, or a gold ETF or in a liquid fund.

If the market is tanking and your equity allocation has dropped below your benchmark level, then only venture into equities. If you are unable to decide which stock to buy, then buy some Nifty BeES or an index fund.

The thumb rule about investing a lump sum amount - which you may have received as a gift, or as a bonus, or due to the maturity of a long-term investment - is to invest all of it, but without deviating from your asset allocation plan.

The best avenues to invest systematically and gradually are additional amounts in your company provident fund (or, Public Provident Fund for the self-employed), a bank recurring deposit, or a SIP in an index fund.

May be all three together. You may be surprised by the tidy sum that will accumulate after 5 years.

Start your own risk free FMP

We have now spent 9 months in a bear market. For investors who had entered the markets in the last 5 years, this is the first experience of how a bear market can destroy wealth.

What we saw in 2004 and 2006 were just bear phases in a bull market, which provided opportunities to buy.  Many small investors jumped in to buy in March and July this year - only to see that there was no real recovery in the markets.

Experts have now started talking about a 4-digit Sensex, and investors who have been in denial for the past 9 months are now thinking and talking about how to protect capital and reduce losses.

The mutual fund industry has been promoting Fixed Maturity Plans (FMPs) of 12 months+ duration and trying to explain the benefits of lower tax against a bank fixed deposit. Of late, they have even started offering 1 month FMPs - and are not mentioning anything about tax benefits!

A small investor trying to protect his capital should start his own FMP and make it completely risk free. How? It is so simple, that it is almost a no-brainer.

Let us say you have some investable cash of Rs 2 lakhs. What are your options?

a) You can buy shares at low prices and watch them go lower;

b) You can buy MF units and watch their NAV drop

c) You can park it in a bank FD for 2 years and earn 10% interest

d) Start your own FMP - start with Option (c) above, but take monthly or quarterly simple interest. Depending on your risk tolerance, set up a recurring deposit (RD) account with 20% or 50% of your monthly/quarterly interest. The balance interest should stay parked in your savings account for periodic purchases of shares and/or MF units. 

After 2 years, when your FD matures your entire capital will be intact, the RD account would be intact as well, and the shares or MF units that you purchase should start showing some real gains, as this bear market should be history by then.

Simple, isn't it? But exciting? No. But who said building wealth is exciting? It is a slow and steady and disciplined process to be carried through for many years.

(I try to preach what I practice. In Oct '07, I had sold a percentage of my holdings in shares and MF units when the market looked overbought. With the proceeds, I opened a 3 years FD with a leading private bank. 20% of the quarterly interest earned is reinvested in a RD. The balance interest is accumulating in a savings account. I have slowly started to reinvest in shares and MF units.)