Why the current state of the stock market makes me happy and sad

The state of the stock market make talking heads in business TV channels happy or sad – depending on whether the indices are trending up or falling down. Their business depends on bull markets, which attracts more viewers and more advertising revenues. But investors are supposed to be dispassionate about the state of the market, right?

Not quite. Most small investors tend to be bulls; i.e. they try to buy low and sell high. They feel happy when stock prices move up during bull markets and their paper profits increase by leaps and bounds. Then they fail to sell at the appropriate time, only to see their paper profits start to disappear. They hang on with the hope that prices will start rising again, and end up feeling sad when profits turn into loss.

Why is the current state of the stock market making me happy and sad at the same time? It is because of recent reader queries and emails I have been receiving. Mostly they ask variations of the same question: “I want to buy XYZ stock; is this a good time/level to enter?” The first part of the query has made me happy for two reasons:

1) The selected stocks have been some of the better known and fundamentally strong stocks. No longer are readers asking my opinion about Bartronics or Suzlon or Geodesic or Punj Lloyd. That shows investor maturity.

2) Most small investors want to buy when the bull market is already at an advanced stage. They buy at a high price with the hope of selling at even higher prices, and become victims of the ‘Greater Fool’ theory. But the current state of the market seems like the tail-end of a bear market or the early stage of a bull market. Wishing to enter now is again a sign of investor maturity.

It is the second part of the query that has made me feel sad, because it made me realise that investor psychology hasn’t changed in 100 years despite the advent of nuclear energy, rocket science and computers. How so? Here is what Larry Livingston (a.k.a Jesse Livermore) mentioned in his reminiscences: “The average man doesn’t wish to be told that it is a bull or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to have to think.”

It also makes me sad that after four years of effort in maintaining a blog, I have not quite been able to simplify technical analysis for lay investors so that they can take their own decisions about when to buy and at what level. Here is another quote from Livingston/Livermore: “Nobody can make big money on what some one else tells him to do.”

Remember and internalise that last quote. You have to depend on your own judgement for long-term investment success. The sooner you make the effort to learn the rudiments of technical analysis – I’ve written a free eBook on the subject – the easier it will be to decide when to buy or sell and at what level.

Related Post

Why investors fall prey to the Greater Fool Theory

When should you 'hold' and When should you 'fold' a stock?

About trend lines and channels

Here are some extracts from my free eBook on Technical Analysis taken from Chapter 2: Trend Lines and Channels:-

“Stock or commodity prices tend to move in a trend. A bullish (or up) trend occurs when demand for a stock or commodity exceeds supply. In other words, there are more buyers than sellers. A bearish (or down) trend occurs when supply of a stock or commodity exceeds demand. That means there are more sellers than buyers.

Some times, demand from buyers and supply from sellers are almost equally matched. The trend becomes sideways – neither going up nor falling down. At such times, technical analysis doesn’t work too well. At some point, a mismatch between buyers and sellers causes a break out from the area of sideways consolidation.

There are three types of trends. A major trend lasts for a few months or years. This is the trend of greatest interest for buyers and sellers. An intermediate trend moves in a direction opposite to the major trend, and lasts for a few weeks or months. Eventually, the major trend resumes. A minor trend occurs for a few days during major and intermediate trends, and is of very little consequence.

Prices don’t move in one direction in a straight line. An up move of a few days is followed by two or three days of a down move, producing a zigzag pattern on the chart. Trend lines enable investors to identify the major and intermediate trends. These lines are drawn by connecting the progressively higher bottoms touched by prices in an up trend, or the progressively lower tops touched by prices in a down trend.

Some times, prices move within trend channels – a pair of parallel lines can be drawn connecting the tops and bottoms touched by prices during an up or down trend. A trend channel is similar to a sideways consolidation, but with an upward (or downward) bias. Eventually prices break out of the channel.

Drawing trend lines (and channels) is a skill that improves with practice. Despite its name, there is nothing ‘technical’ in technical analysis – other than dealing with graphs and geometrical shapes taught in school to every student. The important thing is to remain flexible about adjusting to changing conditions if chart patterns don’t form exactly as per expectations.”

Why remain satisfied with these extracts? Get the real thing. The eBook is absolutely free. Just send me an email at mobugobu@yahoo.com with your full name and a request for the eBook to receive your copy.

Two interesting links on Technical Analysis

Given below are two links to articles that appeared some time ago on the investopedia.com site:

http://www.investopedia.com/articles/trading/07/technical-fundamental.asp?partner=basics011312#axzz1jbaryrEn

http://www.investopedia.com/articles/technical/112601.asp?partner=basics011312#axzz1jbaryrEn

If you are new to investing or technical analysis, these two articles may arouse your interest to learn more.

If you want some of the concepts mentioned in the two links in an eBook form, just send me an email for the free eBook: Technical Analysis – an Introduction.

Free eBook on Technical Analysis – thanks and clarifications

The free eBook: ‘Technical Analysis – an Introduction’ was launched on the last day of 2011 – after considerable time spent at the planning stage. Some important concepts in technical analysis has been covered in brief, with real-life chart examples.

The idea was to generate curiosity and interest among small investors so that they may get motivated to delve deeper into the subject. There are some excellent and comprehensive books – such as the ones written by Edwards/Magee and Martin Pring – which cover technical analysis in greater detail. (The search box of flipkart.com at the bottom of the page can be used for searching books on investment.)

The response from regular as well as new readers has been quite overwhelming, and everyone deserves special thanks for making my endeavour in producing the eBook worthwhile. Some have already finished reading the eBook and provided suggestions for improvement. Reader involvement is appreciated.

A few of the reader feedbacks received so far made it necessary to post a few clarifications about the purpose of the eBook. The most important one is to demystify the subject of technical analysis.

Technical analysis is not a magic potion that will suddenly turn short-term trading losses into profits overnight. Nor will it identify unknown stocks that will turn a Lakh into a Crore within a short time. But knowing the basics will help investors to take more informed decisions about when to enter and when to exit a stock.

A second point worth mentioning is that the eBook is not going to turn novice investors into expert technical analysts. Becoming an expert requires several years of experience and application – as in any other subject.

A third point is that many technical patterns have specific ‘rules’ associated with them. Remembering the pattern but not the rules can cause serious losses. The human mind seems programmed to see patterns where none may exist. Bigger problems are confusing bottom-reversal and top-reversal patterns, and jumping to conclusions about a pattern before it has fully formed.

Last but not the least, is that it isn’t necessary for similar patterns to behave identically. In a recent post on IFCI Ltd, four ‘rising wedge’ patterns were identified - each behaved a little differently from the other. So, it is not enough to identify a pattern. One has to remain flexible about the outcome of the pattern.

If you haven’t yet received a copy of the free eBook, you can get one by sending an email to:mobugobu@yahoo.com

5 strategies to follow in a bear market

Most small investors enter the stock market when a bull market is nearing its peak. They don’t have clear goals and strategies, and get caught on the wrong foot by the bear market that inevitably follows. The trauma of losing money in a hurry can be soul-destroying.

Without the necessary skills and experience of surviving in a bear market, investors resort to all kinds of ill-advised strategies in an effort to quickly recover the losses. That only makes a bad situation worse.

The current bear phases in the Sensex and Nifty indices are 14 months old, and so far there has been very little indication of a reversal in the down trends. Experts are saying that the bear phase can last till the first half of Financial Year 2012-13. If they are right, the bear market may sustain till Sep 2012 – another 9 months!

Whether you are one of the unfortunates who are ‘stuck’ at higher levels, or a more seasoned investor who is sitting on cash to deploy at lower levels, here are 5 strategies that you may want to follow in the current bear market:-

1. Remember that bear market rallies are sharp and swift. Don’t jump in by thinking that you will miss a buying opportunity at a low entry price. Such rallies are some times ‘created’ by bears so that they can sell at a higher price.

2. Just because a stock has fallen to a 52 week low doesn’t mean it can’t fall any lower. As long as the trend is down, it can fall lower. If it is worth buying, being patient can help you to enter at a much lower price.

3. A sharp vertical drop in price – often accompanied by strong volumes - usually attracts a lot of buyers who believe that they are being smart by entering at a low price. It is the sign of a ‘panic bottom’, which seldom holds. Prices bounce up on the buying, but then fall lower than the ‘panic bottom’.

4. At the risk of sounding like a broken record (or, a damaged CD) – do not, repeat do not, average down in price. No one knows how much further a stock’s price will fall, or worse still, if it will ever recover (e.g. Cranes Software). It is far better to average up once the price forms a bottom and starts its up move.

5. Major down trends are not reversed in a day or a week. Bottom reversal patterns take a few weeks to a few months to form. Ability to ‘read’ chart patterns can help investors to accumulate a stock while a reversal pattern is ongoing (refer Chapter 7: Reversal Patterns of my free eBook: Technical Analysis – an Introduction).

If you can’t ‘read’ a reversal pattern, don’t worry. Eventually, prices will turn up and a new bull market will begin. You may enter at a higher price, but the chances of a loss can be minimised by using a trailing stop-loss.

Related Posts

Five things you should avoid in a bear market

Five more things to avoid in a Bear Market

eBook: Technical Analysis – an Introduction

As regular readers already know, I have been writing a blog for more than 3 years to educate new investors about investing in the stock market. The experience so far has been quite enriching for me, and hopefully, beneficial for some of the readers.

The stock market can be a fascinating place or a fearsome place – sort of like bathing in the sea. The first few attempts are usually quite humbling – specially if the sea has large waves that keep constantly crashing on to the shore.

The uneducated can get thrown and dashed around by the waves – hurting pride and self-confidence. In extreme cases, the sea waves can drag out the hapless to a watery grave.

To the experienced sea bather, there can be nothing more exhilarating, invigorating and even relaxing. Jumping up to let the smaller waves flow through, diving under the really big breakers, then swimming out and letting the waves gently carry you back to shore is great fun and builds up a healthy appetite.

Likewise for the stock market. The inexperienced buy to find their stock going down, sell to find the stock going up, spend sleepless nights thinking how to salvage their losses – and in extreme cases, commit suicide.

Of those who have been through the experience, some leave the market permanently blaming brokers, operators, market manipulators, friends who gave wrong tips – in fact any one except themselves. Those who stick around to fight another day, try to learn the ropes by reading, or following the advice of experienced market players.

My earlier eBook: How to become a better investor, was published exactly two years ago on New Year Eve. It contained general advice about sector and portfolio selection, and strategies about how and when to invest without losing a lot of money. Several hundred eBooks were emailed – and may have helped a few readers to become better investors. That eBook is now being ‘retired’ – it will no longer be emailed, but will be available for reading on a different blog.

Many of the posts on this blog are about technical analysis of chart patterns. Several readers had requested me to write an eBook on technical analysis, so that the important information can be available easily in one place. After remaining on the anvil for nearly a year, it is finally ready.

Like the previous eBook, this one is also being provided to my blog readers for free - but on two conditions:

First, you need to specifically ask for the free eBook by sending me an email at mobugobu@yahoo.com with your full name. Hiding behind a pseudonym won't help! I would like to avoid spammers to the extent possible.

Second, you can ask your friends, relatives, colleagues to send me an email for the eBook (or send them a link to this blog post) - but please do not forward the eBook to others without my permission. I don't want the eBook to be freely circulated over the Internet.

The eBook has been compiled from selected blog posts and some new material. It is meant to be an introduction to the subject of technical analysis, with a handful of important concepts that are more than enough to arouse the curiosity of those who want to learn more.

2011 has been a disappointing bearish year for most small investors. Please consider this eBook as a small gift towards making 2012 a happier and more prosperous year. Needless to say, your comments and feedback will be most welcome.

How to use Options as a hedge – a guest post

In Chapter 3 of my FREE eBook, I explained why small investors should avoid Futures and Options trading. The odds for success are too low, and the chances of making a loss are too great for my liking.

I belong to the old school of buy-and-hold investors who prefer to get rich slowly. For younger (and smarter) investors, who are not as risk averse as me, Options can be a useful hedging tool. Nishit explains how in this month’s guest post.

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Options are much misunderstood and much maligned. They are best used for hedging, and not as a gambling mechanism.

To read the basics of Options one can refer to this older post of mine:

http://money-manthan.blogspot.com/2010/12/introduction-to-options-part-1.html

How do we use Options?

Let us suppose we have a portfolio of stocks and feel that the market is going to take a beating. One approach is to sell our stocks and sit on the cash – which is the safer route. Another approach is to write calls and pocket the premium. E.g., when the Nifty was at 5900, we could have sold the 5900 call option at Rs 142 and pocketed the premium. One would have been at a loss only if the Nifty went above 6050, a gain of about 3%.

To buy options you need to pay a premium, and the seller gets the amount the buyer has paid. He is paid this amount in order to compensate the seller for the risk he is taking - the risk of markets rising.

If the markets rise, your portfolio would also have risen proportionately, provided it had blue chip stocks in it. One could do this month after month and earn extra money while at the same time keeping the portfolio intact. This requires a bit of effort in the sense that one needs to know a bit of technical analysis to understand the support and resistance levels.

What-if Analysis

One could come back and ask: why not buy Puts to hedge? The problem here is that Options are like mangoes, a perishable commodity. If the markets don’t fall, you lose your premium. In case of writing calls, you are getting a net inflow and you would only make less money and lose money if the markets rise more than 3%. If the markets rise more than 3%, then you have got your technicals wrong.

Is the converse true? When we feel the markets are going to rise, can we write Puts?

Writing Puts is one of the most dangerous things to do. Why? Most of the falls are sudden and unexpected. The triggers are something out of the blue. Consider the 9/11 events or some assassination or natural disaster.

Writing Puts and Calls leaves one open to unlimited liabilities. In case of writing calls, one has his or her portfolio as a hedge, but in the case of writing puts there is no hedge really. It should be left to big institutions to do.

Writing Puts can be indulged in, when one has bought another put as a cover. E.g., I know the market is at a support level and will bounce form that level. I write a 5700 put at Rs 150 and buy a 5500 put at Rs 60. My net inflow is Rs 90. The maximum loss I can suffer is if market closes on expiry at 5500, which would render the 5500 put worthless and for the 5700 put I would need to pay Rs 200. I have already got an inflow of Rs 90. So, my net loss would be Rs 110.

Options are great hedging tools but need to be handled very carefully.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.) 

10 DOs and DON’Ts for making money in the stock market

Making big money – really big money – that allows you the freedom to do what you want, when you want and wherever you want must be the dream of every human being in the planet (except those who become monks or nuns). Only a few manage to make the dream a reality.

Those who follow the straight and narrow path end up toiling all their lives – slaving at a job, or trying to run a profession or business. Those who prefer a more crooked road usually have a short career and end up as state guests with free room and board – unless they manage to become politicians powerful enough to stay away from the long arm of the law.

Making really big money is not a realistic goal for most law-abiding citizens. But making a lot of money – enough that you can have a comfortable retired life that doesn’t require you to cut corners and lets you enjoy some of the material pleasures that life has on offer – is a more achievable goal. The stock market is a place that can help you to achieve the goal by supplementing your regular earnings.

Here are 10 DOs and DON’Ts for making money in the stock market:

DO…

1. Make a financial plan. You don’t have to be a CA to do this. All you need is a little common sense and some knowledge of arithmetic. Think of all the major expenditures – children’s education, daughter’s marriage, buying a flat – at different times in the future and assess how much money will be required for each. That will give you an idea of how much you need to save.
2. Make an Asset Allocation plan. This is the key. You need to know how much of your savings you should invest in risk-free instruments like Post Office MIS or bank fixed deposits, and how much you can afford to invest in riskier instruments like mutual funds and shares. By maintaining a plan, you will know when to buy and when to sell.
3. Learn about the stock market before entering it. Can you get into an IIT or IIM from the Kindergarten? Can you face the fast bowling of a Brett Lee or a Dale Steyn if all you have played is tennis ball cricket? In the stock market, you will be playing against the likes of Rakesh Jhunjhunwala and Ramesh Damani. If you don’t know what you are doing, they will take all your money. Read books by Gurus like Graham and Lynch.
4. Learn how to select stocks and build a portfolio. Haphazardly buying and selling stocks (or funds) on some one’s advice or your ‘gut feel’ is a sure way to make losses. Learn the process of selecting stocks for a portfolio, and holding for the long-term. There are several articles on this blog that can get you started.
5. Learn to be patient and disciplined. The stock market is not a place for showing off how smart or enterprising you are. Those qualities are great for a business venture. In the stock market, you have to be observant and vigilant. Choose the times you want to buy (near bear market bottoms) and the times you want to sell (near bull market tops) carefully. The rest of the time, just wait and watch. Rome wasn’t built in a day. Neither will your wealth.

DON’T…

1. Think that making money in the stock market is easy. The stock market isn’t a zero-sum game. While there is a buyer for every seller, only a few make money. The majority lose. They are the ones who thought making money was easy.
2. Feel like a genius if you have made some money. It was most likely a combination of luck and a bull market. Going through bull, bear and sideways markets with your wealth intact requires determination and perseverance. If you are feeling excited and having fun, a loss is just around the corner.
3. Forget Buffet’s Rule No. 1. Regardless of whether you have a shorter or longer investment time frame, always set stop-losses. That will help you to limit your losses. If a stock is running up fast, set a trailing stop-loss. (If you don’t know anything about stop-losses, you need to read my eBook. It is FREE.)
4. Be too greedy. Have profit targets for each stock (or fund) in your portfolio. Once the target is hit, sell 50% and hold the rest with a trailing stop-loss. Sell all when the trailing stop-loss gets hit.
5. Ever trade. According to Peter Lynch, the odds of success are greater at the race track or casino. Most trade to get rich quick. But there are no short-cuts in life. Trading is the best way to get poor quick; or, to become a reluctant long-term investor (when the trade goes completely wrong!).

There are no sure-shots in the stock market. But if you follow this simple set of DOs and DON’Ts, you will make a lot of money. Not tomorrow, or the day after. But after 20 years. Might as well get started now.

BSE Sensex Index Chart Pattern – Sep 03, '10

The BSE Sensex index chart pattern reminds me of one of the many quotes attributed to the colourful former NY Yankee’s coach, Yogi Berra: “You got to be very careful if you don’t know where you are going, because you might not get there!”

In last Saturday’s BSE Sensex analysis, the technical indicators were looking weak, hinting at a deeper correction. The FIIs had also started selling, after being net buyers throughout Aug ‘10. I had advised readers not to panic, and to watch the FII trading data closely.

On Fri. Aug 27 ‘10 and Mon. Aug 30 ‘10, the 50 day EMA provided good support to the Sensex. But on Tue. Aug 31 ‘10, the index fell below the 50 day EMA intra-day and touched a low of 17820 – a fall of over 650 points (3.5%) from the Aug 19 ‘10 peak of 18475.

Just when it seemed that the pendulum was beginning to swing towards the bears, a smart bout of buying and end-of-the-month short-covering saw the Sensex close the day above the medium-term moving average. From Wed. Sep 1, ‘10, the FIIs became net buyers again and the index moved above the 20 day EMA.

I’m not very sure where the Sensex is going – or whether it will get there. But let us try to look for some clues in the 9 months bar chart pattern of the BSE Sensex index:

In Mar ‘10, the Sensex was making new highs while the RSI peaked out and started moving lower. The slow stochastic remained flat. The negative divergences were followed by the index touching the upper end (18048 on Apr 7 ‘10) of the upward-sloping trend channel and reversing directions.

The Sensex (marked by blue oval) dropped to the 50 day EMA, got support and then bounced up above the 20 day EMA. Observe the RSI (within blue oval) closely. It dipped below the 50% level, rose up to touch the mid-point and even as the Sensex rose a bit higher, the RSI started to drift down. The slow stochastic touched the 20% level, bounced up and then moved marginally above the 50% level.

Now, fast forward to the Jun-Aug ‘10 period. Note that the gradual higher tops in the Sensex were once again not matched by the RSI and slow stochastic. The negative divergences were a precursor to the brief correction from the Aug 19 ‘10 top of 18475.

Let us see what happened last week (marked by blue ovals again). The Sensex dropped below the 50 day EMA intra-day but closed just above it. The subsequent bounce took the index above the 20 day EMA – almost repeating what happened back in Apr ‘10. As Yogi Berra might say: “It’s deja-vu all over again!” 

Observant readers may perceive a subtle difference. The RSI dipped below the 50% level, but rose above it. The slow stochastic touched the 20% level and then moved slightly higher above the 50% level.

What can we conclude from these observations? The odds are favouring the bulls a bit more. A drop to the lower end of the trading range may not happen just yet. A test of the upper end of the trading channel seems more likely.

But I’m not ready to place any bets. Why? I’ve learned the hard way (by losing money) that it is pointless to bet on Sensex movements. The double-digit inflation number consequent to high food prices is also a cause of concern. Not to forget that the Sensex is just 250 points (<1.5%) below the recent 52 week high.

Bottomline? The BSE Sensex index chart appears to be repeating a pattern it followed back in Apr ‘10. It really shouldn’t matter to investors which way the Sensex will move next. Stay invested with appropriate stop-losses. The index has spent a year inside the upward-sloping channel. It may be a good time to adjust your asset allocation plan.

(Note: If you don’t know how to reallocate your assets, read my FREE eBook.)

The Sensex has made a new high - are you feeling excited?

When the Sensex moves up towards a new high, the excitement becomes palpable all around. Unwanted SMSes and emails start flying around recommending stocks that no one has heard of and may not even exist!

Every day that the index moves up by 50 or 100 points, the talking heads on business channels bestow beaming smiles at the camera and talk about 'another good day' in the markets. If the index falls 75 points, the smiles disappear and solemn-faced comments pour forth - like, 'not a great day, may be tomorrow will bring some cheer'.

Participation in investment group discussions increase by leaps and bounds. Every one wants to buy. A paint company meandering below 600 for several weeks suddenly jumps up like a jack-in-the-box, and every one who ignored it earlier is now desperate to get in at 800 in the hope of seeing 1000.

The global economic situation is no longer grim, but has a long way to go before real and sustainable growth becomes visible. No wonder FIIs are pouring in money into Asian markets that have not only survived the down turn but are back on the earlier growth track.

How long will the current bullish fervour last? No one really knows. When some one else is paying for your (bull) party, why worry about when the party will end? Enjoy yourself while it lasts.

Like all parties, the good times will come to an end. Will you be the one who passes out on the floor and won't be able to get to work the next day? Today's trading made a 'reversal day' pattern - a higher high but a lower close. A sign of distribution?

Just buy two insurance policies, and you will have nothing to worry about. First, lock your cheque book in a cabinet and hide the keys. Second, for each and every stock in your portfolio, set tight trailing stop-losses. (If you don't know how to set trailing stop-losses yet, then you haven't read my FREE eBook.)

While it may be a good idea to be a contrarian - and be bearish when the whole world is excitedly becoming bullish - please don't make the mistake of selling every stock you own and move to cash. That is 'market timing' at its worst and can seriously erode your ability to become wealthy.

As you may have noticed, stock prices tend to rise in brief spurts, followed by longer periods of little or no upward movements. Unless you remain invested in the market, you will miss out on these price spurts in individual stocks.

By all means book partial profits, in stocks that have run up too high, or, to rebalance your portfolio. But do stay invested in your carefully built-up portfolio with trailing stop-losses, and sell when the stop-losses are hit.

If all you own are small-cap shares of questionable pedigree and management, then use this up move to sell out. When the correction comes - which it inevitably will at some point, make sure you use the cash to buy the L&Ts, and ITCs, and M&Ms, and Glaxos, and other such stalwart stocks. 

Strategies for buying and selling stocks and mutual funds – analysis of readers' exercise (Part II)

Last week, I had analysed the first three questions of the readers' exercise about strategies for buying and selling. Today, the balance three questions are being addressed. To jog reader memories, and for the benefit of those who missed the earlier posts, here are the last three questions:

Q4. You had bought 500 shares of a small cap company about 2 months back. After stagnating for a while, the price recently shot up by 25%. Will you:

(a) sell all 500 shares and book short-term profits?

(b) sell 250 shares and reduce your holding cost on the balance shares?

(c) hold on for higher prices?

(d) buy another 200 shares at the 25% higher price?

Q5. You had bought 1000 shares of another small cap company about 6 months ago. The stock has been stagnating since then. A recent announcement of 20% dividend and a stock-split perked up the price by 10%. Will you:

(a) use the up-tick in price to sell out?

(b) wait for the dividend and stock split and then decide?

(c) buy another 250 shares at the 10% higher price?

Q6. You have been holding a well-managed mid cap MNC company's stock for a couple of years. The company recently announced delisting of its shares from the stock exchanges at a buy-back price that was 15% higher than market. Subsequently the price has spurted by 30%. Will you:

(a) hold on with the hope that the company may increase the buy-back price?

(b) sell your entire holding at the current market price?

(c) sell 80% of your holding now, but keep 20% aside in case the company increases the buy-back price?

(d) sell to the company at the announced buy-back price?

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Q4 and Q5 appear similar, but I would like to point out the differences. Small cap stocks are inherently risky because few analysts cover them and there is little information publicly available about their operations.

As small investors, it should be our primary goal to reduce the risk of losses. A spurt of 25% in 2 months is equivalent to an annual gain of 150%. The logical answers should be (a) or (b). Option (c) won't reduce the risk. Option (d) will increase the risk by buying more at a higher price.

If you have read my post about 'How to use Financial News', you will know that dividend and stock-split announcements can be classified as 'good news'. The effect of such news on the stock's price is temporary - lasting not more than 2-3 days - so it doesn't make much sense to trade on it. So, the logical answer should be (b).

A few words about stock-splits and bonus issues may be in order. In small caps, unscrupulous promoters often announce splits or bonus to jack up the stock's price through circular trading, only to cash out at the higher price and leave small investors in the lurch.

But reputed promoters either use stock splits to increase liquidity of high-priced stocks, or announce bonus shares to indicate that the company is in good enough financial health to shoulder the liability of the increased equity capital.

Theoretically, stock splits and bonus issues do not add to investor wealth because the stock's price gets adjusted after the split/bonus. But what actually happens in the market is beneficial for investors who hold for the longer-term.

Once the increased number of stocks following the split/bonus is credited to investor accounts, there is a tendency towards some selling, which reduces the split/bonus adjusted price some more. After a few months, the selling subsides and the stock price starts to move up again.

For well-managed companies, the price eventually surpasses the split/bonus adjusted price. Typically, a dividend paying company reduces the per-share dividend according to the split/bonus ratio, so that the dividend received by investors prior to the split/bonus remains the same.

Over the next few years, if the per-share dividend is increased (which is often the case), investors gain on both capital account and dividend account without investing a single paisa.

For the last question, option (b) should be the logical answer. Options (a) and (c) are speculation and not investment options. Option (d) leads to capital gains tax as per current rules, since selling to the company does not incur STT (securities transaction tax).

If the stock is infrequently traded, and an investor holds a large chunk, then option (b) may not be practical. Investors would have no choice but to sell the shares back to the company.

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A Clarification about subscribing to my Monthly Investment Newsletter

The recent announcement of re-opening of a limited number of subscriptions to my Monthly Investment Newsletter has received a very encouraging response from readers, several of whom have signed up already.

Some readers who received and read my FREE eBook: 'How to become a better Investor', may have assumed that the subscription to my Monthly Investment Newsletter was also free. It isn't. It is a pre-paid subscription. I do regret any confusion.

If you are interested in subscribing to the Monthly Investment Newsletter, send me an email at mobugobu@yahoo.com for details. But do so at the earliest. Subscriptions will close on July 21, 2010.

The 7 Steps to Success in Stock Market Investments

Before readers get all excited, I have a disclaimer. The 7 Steps to Success is a sure-fire, fail-safe method for making money in the stock market over the long-term. What it isn't is a short-cut to success. There aren't any short-cuts to success.

To achieve success in any endeavour - be it in the field of education, or sports, or any profession - requires discipline, an ability to concentrate on the important issues, diligence, hard work, persistence and patience.

The stock market is no exception - contrary to what most investors may think before they jump in feet first and lose their shirts. I have been there and done that, and learned the hard way.

Without much further ado, here are the 7 Steps to Success in Stock Market investments:-

Step 1: Develop a reading habit. Business magazines, pink papers and books on investments. Not every one likes to read - particularly if the language is other than one's mother tongue. For success in the stock market, you don't need to know everything. But you need to know where to go to find the answers. Before investing a single Rupee, read 'One Up on Wall Street' by Peter Lynch.

Step 2: Learn how to read an Annual Report. The most important starting point should be the Cash Flow Statement, followed by the Balance Sheet and the Notes on Accounts. The real information is usually hidden there. Most investors take a cursory glance at the Director's Report, may be the Management Discussion and Analysis, and the Profit and Loss statement to check the dividend amount.

Step 3: Refresh your knowledge about grade school arithmetic. If percentages, ratios, graphs, the concept of compound interest and pages full of numbers scare you witless, you won't be much good at stock investing. Since you learned most of the stuff in school, you can and should be able to re-learn the stuff.

Step 4: Make an honest assessment of your financial situation and risk tolerance. Every investor has different requirements. If you are already bent over with the weight of EMIs and credit card debt, the worst thing you can do is try to make some quick money in the stock market. You will get into a deeper hole. Put the 'can't afford to lose' portion of your savings in fixed deposits, PPF, NSC, Post Office MIS schemes.

Step 5: Prepare an asset allocation plan, and stick to it. Within the equity portion of the allocation, maintain 75-90% in a core portfolio of fundamentally strong large-cap stocks/funds. The balance 10-25% can be in a satellite portfolio of mid and small-cap stocks/funds. (If you don't know how to allocate your assets, you probably haven't read my eBook. It is FREE and you can get it by sending me an email request.)

Step 6: Once you have built a good portfolio, monitor it once a week at most. Just as a sapling won't grow faster into a tree if you stare at it every day, neither will your portfolio. Enterprise and activity may be a requirement in other fields, but they are a detriment to investment success. Learn how to be actively passive - if you can pardon the oxymoron.

Step 7: Warren Buffett revealed an investment success secret - 'Be greedy when others are fearful, and fearful when others are greedy'. He is an acknowledged master, and I am his unknown follower. But here is another investment success secret - 'Cut your losses quickly and let your profits grow slowly'. You can do that by learning to set a stop-loss and a trailing stop-loss respectively. (The concepts are explained in my FREE eBook.)

Did you read my FREE eBook 'How to Become a Better Investor'? Really?

After emailing several hundred copies of my FREE eBook 'How to become a Better Investor', I was taken aback by a large number of reader responses that went like this:

'I've been too busy at work and haven't found the time to read the eBook yet'; or, 'The eBook got buried in my inbox, can you please forward another copy'; or, 'I've been travelling overseas and will read the eBook once I return to India.'

I had deliberately kept the chapters short and the total number of pages to around 30 so that readers will find it easy to read it through. So what happened? Are readers really too busy to read an eBook of 30 pages? Or, in this age of Internet, smart phones and TV, have investors forgotten their reading habits?

Whatever be the reasons, to become a successful investor, inculcating a regular reading habit is of utmost importance. It doesn't matter whether your portfolio is up by 10% or 200%. Looking at the ticker and counting your profits will not prevent investment mistakes.

By reading and re-reading the better known investment books, good investing tricks and strategies will gradually become ingrained in your brain. But before you can contemplate reading Graham's 600 page tome, 'The Intelligent Investor' (if you haven't read it yet, you really should!), you have to first practice by reading my 30 page eBook!

Even after investing for more than 25 years in the stock market I try to find interesting investment books to read - for new ideas and strategies. Why? Because no plan or strategy seems to work for a prolonged period. Just when you think that you've learned it all, the market surprises you with an unexpected jolt.

Recently, while reading William O'neil's 'How to make money in stocks', I came across a simple idea that I felt like sharing. This idea works better for short-term investing, but can be used for long-term investment with suitable modifications.

It is the 3-to-1 rule for setting stop-losses - some thing that every investor should learn, particularly in the current state of the stock market, which is moving sideways in a broad range. Here is the simple rule:

If you expect the stock to rise by 5%, set the stop-loss at 1.5%. If you are buying for a minimum 25% up move, set the stop-loss at 8%. On no account should the stop-loss be greater than 8%.

If you are buying a Rs 20 stock (which will be a pretty risky thing to do now) and expecting to sell at Rs 22 for a 10% profit, the stop-loss should be at Rs 19.40. If you are expecting to sell at Rs 25, set the stop-loss at Rs 18.40.

The stock should be sold as soon as the stop-loss is hit. What if the stock moves higher than expected? Increase the stop-loss by the same percentage (a trailing stop-loss).

Investors lose more money by sitting on their losses and rationalising the loss by saying that they are long-term investors. A loss is a loss - whether it is booked, or remains in your demat account. By limiting your loss to a maximum of 8%, you will not get swamped by a 2008-like tsunami of selling.

Chapter 2 of the FREE eBook describes how to set trailing stop-losses. Even if you don't read any other chapter, read that one and internalise the idea.

The Sensex fell 120 points - is it time to hit the panic button?

Regular readers of this blog will not even think about hitting the panic button just because the Sensex fell 120 points. They would have heeded my recent advice about being prepared for a possible correction as the index approached the Jan '10 top.

Probably just routine profit booking after four straight up days. May be even an effort by bulls to trap the bears. Why? Because the FIIs were net buyers even today and market breadth was positive after several days. That means, index heavyweights were sold (e.g. Infosys, HDFC) which pushed the index down and stocks outside the index were bought.

However, the fact that the Sensex tested the Jan 6 '10 top of 17790 two days in a row and briefly crossed it to hit 17793 on Mar 29 '10 before retreating by 200 points could also be a sign that an intermediate top has been made. So the index could be heading down soon.

The advance-decline line is showing a huge divergence with the Nifty index (thanks to reader Sanjeev - who sent me the link to the chart at the icharts.in site):-

Note that during Sept and Oct '09 there was a wide divergence between the falling A-D line and the rising Nifty index which culminated in a sharp correction.

From Nov '09 to Feb '10, the Nifty index and the A-D line moved together in lock-step. Post the budget, the Nifty index has soared while the A-D line has plummeted. Such a situation is unlikely to continue much longer.

Investors can play this three ways:

1. Book profits and wait for the correction to re-enter. That will be the riskiest way.
2. Book partial profits to generate some cash that can be redeployed during the correction. Less risky.
3. Stay invested with strict stop-losses - say, around 5150 for the Nifty and 17200 for the Sensex. Of course, this assumes that you are invested in index funds or index ETFs.

For individual stocks, the stop-loss levels should be placed at the previous (lower) tops. If the Sensex resumes its rally, remember to maintain trailing stop-losses.

(If you don't understand how to set stop-loss levels or what is a trailing stop-loss, you should read my FREE investment eBook.)

Related Post

Why you should forget about the Sensex and Nifty and look at the Advance-Decline (A-D) line instead

How to overcome Uncertainty in Stock Market investing

Many investors shy away from investing in the stock market because of the uncertainty of making any profits. A fixed deposit in a bank or an investment in a PSU bond has much less uncertainty. You are pretty much assured of getting back your invested capital, as well as earning some interest income.

In the stock market, there is uncertainty about receiving any income because a company is not obliged to pay any dividends even if it is making super profits. For example, a profitable company like Bharti Airtel paid its first dividend only in 2009 - 7 years after going public.

And there is uncertainty about getting back your invested capital. If you had bought Bharti at 600 in Dec '06, and sold at today's closing price of 300 (2:1 split adjusted) you would have actually lost a small part of your capital due to brokerage and tax payments.

But these are uncertainties that can be managed and, to a certain extent, measured. What we term as 'risk' is nothing but the possibility of having an unfavourable outcome. We can try to reduce the risk by quantifying the uncertainty of the outcome. How?

Let us say, you plan to buy 100 Tata Steel shares @600. You assign a probability of 80% that the stock will test its recent high of about 650.  There is also a 20% probability that the stock may drop to its 200 day EMA at 520. That means a 80% chance that you will make 5000 but a 20% chance that you will lose 8000. Your risk of loss can be quantified as: (600-520)x100x0.20= 1600.

After looking at the numbers, will you still decide to buy Tata Steel at 600? There is no reason why you shouldn't - specially if you have learned to set a stop-loss for all purchases. (Don't know how to set a stop-loss yet? You have only yourself to blame - because it is clearly laid out in Chapter 2 of my FREE eBook.)

What stock markets dislike are uncertainties associated with external factors and events, such as rate of inflation, interest rates, quarterly earnings results, oil prices, war, terror attacks, political climate. Adverse effects of such uncertainties usually get reflected immediately with 2 or 3 days of correction. Smart investors use such dips to buy.

But the worst uncertainty is about the state of the economy. If there is a possibility of a recession or a depression, stock markets tend to tank as investors rush to the exit doors and invest their money in safer havens.

The best way to overcome the fear associated with uncertainty is to always stay well-informed about the business and economic environment around you. Most business magazines and newspapers have web editions that you can browse without leaving your seat. Also visit web sites like CNN Money, FT and WSJ Marketwatch to get an international perspective. Make it a daily habit.

Why investors board the wrong train and then refuse to get off

Why is it that many investors seem to specialise in boarding the wrong trains (read: stocks) and then simply refuse to get off, even though logic and common sense dictates otherwise?

After watching part of the presentation of the Railway budget, where the honourable minister thoroughly entertained the treasury benches as she took on the opposition by throwing taunts at them, I was reminded of a movie I had watched several years ago.

In the British film 'Clockwise', a very uptight and ridiculously punctual headmaster, played by John Cleese, is invited to speak at the headmaster's conference at a distant town.

He diligently prepares for the visit, goes to the railway station well on time, boards the train and starts memorising his typed speech - only to realise too late that he had boarded the wrong train.

He quickly gets off, but misses his own train and then faces one hilarious misfortune after another as he desperately tries to ensure that he is not late for the headmaster's conference. To cut a long story short, he eventually reaches the conference on time - in a dishevelled and chastened condition.

The moral of the story? Trying to be too punctual can create unnecessary situations, including boarding the wrong train. But getting off quickly may ensure that you reach your destination on time.

Many investors would rather follow the stock ideas of others than learn to do the hard work of stock selection themselves. That can create serious financial problems.

Either one buys into a momentum stock with questionable fundamentals. Or, even worse, one buys a fundamentally strong stock after it has already run up a lot and the smart money is getting out.

End result is the same. One is stuck with a stock bought at higher prices. Then begins a prolonged period of 'loss aversion' - asking questions at different investment groups about the future of the company and when one can get back one's 'buy price'.

Not selling a losing position in the hope of breaking even may be the biggest cause of losses faced by small investors. There is only one solution. Get off the train! If you learn how to set stop-losses, you will incur smaller losses.

(Haven't learned how to set stop-losses yet? Read Chapter 2 of my FREE eBook.)

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.

What can small investors learn from the Put-Call Ratio (PCR)?

Before launching into a discussion about the Put-Call ratio, I need to make a disclosure. I strongly feel that small investors should stay far away from Futures and Options (F&O) trading. Most options contracts expire worthless and investors lose the premium amount that they had paid.

(I had made this point very clear in 'Chapter 3: What are your Future Options?' of my eBook. Haven't got your copy yet? Get your FREE eBook today!)

A put option owner has the option, but not an obligation, to sell the underlying security (a stock or an index) at a pre-determined price within a specified time. Likewise, a call option owner has the option, but not an obligation, to buy the underlying security at a pre-determined price within a specified time.

The Put-Call ratio (PCR) is calculated by dividing the total number of put options traded by the total number of all options traded. A ratio of more than 1 means more put options were traded than call options (i.e. more investors were feeling bearish). A ratio 1 or less means more call options were traded than put options (i.e. more investors were feeling bullish).

If small investors are supposed to stay away from F&O trading, why should they be interested to learn about the Put-Call ratio? The short answer is: the PCR is a short-term contrarian sentiment indicator.

As stock market indices drop near a bottom during a bear market, investors turn extremely pessimistic in panic and fear and expect to see further downsides. Many more put option contracts are traded than call options, and the PCR ratio keeps going higher.

How high is high? There are no fixed benchmarks. But a ratio of 1.5 or more means that bearishness is becoming excessive. As option traders are generally incorrect in their market sentiment assessment, a high PCR is taken as a contrarian 'buy' signal.

When stock market indices rise to a top during a bull market, investors become excessively greedy and euphoric and expect to see newer highs. More call options are traded than put options, and the Put-Call ratio drops below 1. This is used as a contrarian 'sell' signal.

Most business channels and pink papers make a big noise about the PCR. Just keep your eyes and ears open. Whenever the PCR gets to 1 or less, a correction may be close at hand. When the PCR gets near 1.5 or higher, it may be a good time to enter.

Like all technical analysis indicators, the usefulness of the Put-Call ratio (PCR) should be taken with a pinch of salt. It is not infallible. So never take buy/sell decisions based only on the PCR indicator. It should be used in conjunction with other indicators.

Try to avoid the simultaneous switch

What is a simultaneous switch? It is when you sell a stock to immediately buy another. The simultaneous switch is quite a common practice amongst small investors - usually followed by the less experienced ones. But it is a mistake, and needs to be avoided if you want to succeed as an investor.

Why is an investment mistake to be avoided? Because you end up losing money. And avoiding losses is the only rule of investing. Remember that the stock market is not a zero-sum game.

Each buy order needs a sell order for the transaction to be completed. But if you buy 1000 shares, it doesn't mean a single seller sells the entire 1000. There could be several sellers of 100-200 shares each. If the stock shoots up after your purchase, you 'win' and 5 or 6 investors 'lose' (or, 'win' a much smaller amount).

A smaller percentage of investors make money. The majority lose. To make money from stocks, there has to be lots of losers. You don't want to be one of them!

Why is the simultaneous switch a mistake? It is a form of 'timing' the transaction which is fraught with risks. One is trying to make a sale and trying to make a buy at the same time. It is a rare occasion when a good time for selling one stock is also a good time for buying another.

The 'need' for a simultaneous switch occurs during bull markets. Small investors often enter late. In an effort not to miss the bus, they end up spending all their spare cash in buying some of the 'hot stocks' that have already run up a lot.

These 'hot stocks' may not provide great returns over the short-to-medium term. As sector rotation occurs and a different set of 'hot stocks' shoot up, investors get rid of a few of the non-performers (or the ones in which they have made small profits) and simultaneously re-deploy the money into another set of stocks.

This may provide a lot of excitement, but doesn't greatly enhance wealth building. When the next correction comes, there is hardly anything left in the kitty to pick up the bargains.

In a previous article, I had mentioned three reasons why one should sell a stock. Those reasons can not be reasons for buying. Learn the mental discipline of separating the reason for selling from the reason for buying, and avoid the temptation of the simultaneous switch.

(Note: If you are not sure how to time your selling, you need to learn about and implement an asset allocation plan. Read Chapter 12: How to Reallocate your Assets from my eBook. Haven't got your copy yet? Get your FREE eBook before it is too late.)

Have you taken some profits home?

Two weeks back I had suggested that investors should take some profits off the table in this post. The BSE Sensex moved up to make a new high of 17790 on Jan 6 '10 - very close to the target of 17800 mentioned in a post on gap-analysis back in Sept '09.

The expected long-term resistance from the 17500-18000 zone kicked in, and the Sensex started to drift down and closed today at 17422 - almost the same level at which it had closed two weeks back. If you haven't booked some partial profits already, this may be a good opportunity to do so.

The Q3 results season is upon us, shouldn't one wait to check out the results before booking profits? Yes, if you are stock specific - and you should be. Volatility in the Sensex doesn't affect all stocks equally. One should concentrate on the stocks in one's own portfolio.

But don't forget that stock markets generally 'discount' good or bad news months in advance. If you own stocks that make up the Sensex (or Nifty) index, and if such stocks have risen a lot already and are now showing signs of hesitation - then they may fall if the results are perceived to be less than great. Only positive earnings surprises can cause them to rise more.

What if you have booked some profits already? Don't get anxious because the Sensex isn't correcting. Also, curtail your impulse to jump in if the market starts to move up. That is the challenge in the stock markets. To keep your cool, and be patient - like the South African python mentioned in Chapter 4 of my FREE eBook. (If you haven't got a copy of the FREE eBook yet, get it now by sending me an email request.)

If you would rather not time the market (it is a difficult task for most investors), park your profits in a liquid fund and make monthly withdrawals from it to invest in an index fund or Nifty BeES.

What you should definitely avoid is to sell out completely and sit on cash. That is investing suicide in the midst of a bull market.