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Investing with the herd

The Neverights must read our cover story on investor psychology and how certain behavioural traits and attitudes towards money can be financially ruinous.

Print Edition: May, 2010

Mr Neveright: We must invest in stocks now.
Mrs Neveright: Again? Didn't you promise not to dabble in shares after the big crash of 2008?
Mr Neveright: I did, but look what happened. The Sensex bounced back to the same level. If we don't invest now, we'll miss the bus.
Mrs Neveright: But your stocks have not bounced back. They were quoting at Rs 2.50 last month.
Mr Neveright: I know, but the broker says it will zoom when the company is taken over.
Mrs Neveright: Why don't you buy mutual funds instead? A new fund was launched last week.
Mr Neveright: In a fund, you don't have control over the investing decision. Why should I trust the fund manager with my money?

The Neverights must read our cover story on investor psychology and how certain behavioural traits and attitudes towards money can be financially ruinous. Mr Neveright suffered heavy losses in stocks in 2008 and vowed to stay away from the markets. Now that the markets have reached high levels again, he is contemplating investing in stocks.

Rushing in when the markets are high and staying away when they are low is a common mistake that small investors commit. Mr Neveright was fearful when he should have been greedy. And now, when he should be fearful, he is being greedy.

This is not Mr Neveright's only folly. His stock selection has been random and largely based on tips and rumours. He picked up a penny stock because his broker claimed that the company was a takeover target. The problems don't stop here. Instead of cutting his losses, Mr Neveright is holding on to the share in the vain hope that its fortunes will turn around when a white knight in shining armour takes over the company.

The truth is that penny stocks are low priced because they don't offer any value. If they did, they would not be priced at a fraction of their face value of Rs 10. The sooner Mr Neveright realises this, the better it will be for him.

Small investors also make the mistake of getting emotionally attached to a stock or its price. They hold on to losing stocks for too long and offload winners too soon. If they suffer a loss with one stock, they will try to recoup it from the same stock. The probability of this strategy working is minuscule. If a stock is down almost 90 per cent from its purchase price, it will have to rise 900 per cent to regain the loss. That's an unreasonable expectation given that penny stocks are the first to fall during bear phases and the last to rise when the bulls come back.

Mr Neveright's misplaced logic is mirrored in one of the cases before the Portfolio Doctor this month. Bengalurubased Rajkumar Subbareddi started investing in stocks through SIPs in ELSS funds way back in December 2005. All went well till 2007, when he stopped the SIPs and started picking stocks— largely mid-cap and small-cap—on his own. He also invested Rs 1 lakh in two ELSS funds at one go. After the market crash of 2008 wiped out the gains made over two years, Subbareddi decided to stay away from stocks. Today, Subbareddi is a wiser man. He wants to pare down his stock portfolio and resume investing in mutual funds to achieve his goals.

Mrs Neveright's suggestion to invest through mutual funds sounds sensible. However, she needs to get the basics of mutual fund investing right before they do so. Instead of choosing a fund on the basis of its investment mandate and long-term performance, she recommends a newcomer. This is akin to hiring a fresh graduate instead of an experienced worker and could prove disastrous for their finances. Like most small investors, Mrs Neveright has been taken in by the marketing hype and the fact that the new fund's NAV is only Rs 10 compared with the existing funds. It doesn't matter whether the NAV is Rs 80 or Rs 10. Your returns will be defined not by the price but by how well the stocks in the fund's portfolio perform.

Our second case this month, Delhi-based Ranjan Jha, understands this only too well. He has one of the oldest and best performing tax-saving mutual funds in his portfolio. The Magnum Taxgain is his one-stop shop for tax savings, wealth creation and equity exposure. "I don't have Provident Fund or pension from my employer, so my mutual fund investments take care of my tax planning," he says.

But Mr Neveright does not believe in mutual funds. He prefers to have complete control over his investments. This obsession to control drives many small investors to stocks even though they don't have the aptitude or the knowledge to select stocks. He should compare the returns from his stocks with those of the top five diversified funds. If he has beaten the returns of those fund managers, he is obviously in the wrong profession.

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