The dos and don'ts of buying stocks

The dos and don'ts of buying stocks

Rajesh Kumar, Outlook Money January 19, 2007

So you've made up your mind to invest in the stock market. Having overcome initial inhibitions, you're now looking to become a millionaire overnight. After all, if your friend A or your cousin B could do it, why not you?

For investment-innocents, here's a shocker: It is not where you invest your money, but how you invest it that decides the profits. That is to say, stocks are only as good as the investor; they respond to the individual's abilities and acumen. In that sense, stocks are quite distinct from consumer durables. You can reasonably expect a washing machine to perform as well for you as for your neighbour, but that is not the case for stocks, which are a different breed altogether.

So, instead of investment tips, here are some attitude tips.

Don't commit large amounts of money or short-term money. Even if you can afford to take risks, we suggest you don't commit large sums of money - at least not in the initial stages. It would be wiser to start with small amounts and increase your investments as your confidence and grasp of the markets grows. It is not easy to pick up the right stocks or keep track of them when you are starting out.

Also, don't break FDs to invest in rising markets. Always invest the surplus, money for which you have no immediate plans. Equity, as an investment, carries in-built risk and volatility and investing short-term money may force you to quit at the wrong time.

Do be sceptical of self-proclaimed experts. As an investment ing�nue, stay away from self-proclaimed experts or overzealous advisers. The so-called 'hot tips' they offer to investors are largely short-term trading tips, which are very risky for a retail investor. Because the reaction time is limited, chances are you will end up losing wealth.

Similarly, TV gurus and the like are forever ready with "buy" recommendations; few, if any, come out with "sell" advisories for your advantage.

Further, expert recommendations often have vested interests. Recently, market regulator Securities and Exchange Board of India fined an expert for acting exactly contrary to his own recommendations. To curtail such rogue elements, the market regulator is planning a law to govern experts, who comment on the markets in the mass media.

Don't trade for short-term. Short-term trading or day trading is very risky and not recommended for retail and small investors for two reasons. First, it requires lot of time, which small investors can rarely spare since it is not their primary business. Second, retail investors may not have the necessary skills and tools required for short-term and day trading. Do not try to time the markets: it's one of the most difficult things to do.

Invest long-term in fundamentally strong companies. Our advice to retail investors is to invest long-term in fundamentally strong companies. Give your portfolio adequate time to grow. Do not panic in technical corrections. If you are invested in fundamentally strong companies, you are safe. We saw two sharp corrections in 2006, first in May-June and again in December. On both occasions, the market bounced back and crossed previous highs because the fundamentals were intact.

Don't ignore stock fundamentals. There is no set formula for fundamental analysis. You have to study various indicators like sectoral growth, company growth - both top and bottomlines - and various ratios like price to earning ratio, price earning to growth, dividend yield, book value, price to book value, price to sales ratio, debt-equity ratio, return on capital employed, to name just a few.

If number-crunching is not your cup of tea, you must still investigate the nature, business and size of the company and its growth in the last three years - sales, profit and earning per share - all of which are accessible on the websites of stock exchanges.

Do not be tempted to buy small caps and penny stocks. The risk involved in small companies is huge, but higher risk may not necessarily lead to higher gain. That is not to say that you should ignore small companies completely, but at the same time you must have solid reasons for buying into them. And when you do, make sure they are only a small portion of your portfolio.

Do be critical of media reports. It's tempting, when you are just about beginning to follow the jargon, to buy into glowing media reports about corporates. But they could be misleading. For instance, you may read of a company setting up a new plant. Such announcements usually push up prices in anticipation of earning growth.

Before you join the queue for their stocks, you need to understand the cost benefit of the new plant. Ask yourself a few questions: where is the money coming from�equity or debt? If it's equity, how will it impact the EPS in the near future? If the source is debt, is the company in a position to leverage the increased debt? What will be the gestation period? When will the earnings really start coming in? What will be the return on capital employed?

Don't follow other investors blindly. People often talk about their success in the stockmarket, rarely of their failures. Your friend may have made money in the past, but there's no guarantee he will continue to do so in future.

If, however, he offers to share his stocks research with you, welcome the opportunity. It will help you build your own research, but remember it is not a substitute for your own investigation.

Do stay away from a large number of stocks. Investors generally hold a large number of stocks in the name of diversification. But this may not always be the case.

Harry Markowitz, known as the Father of the Modern Portfolio, warned investors: "Holding securities that tend to move in concert with each other does not lower risk." A truly diversified portfolio, he said, comprises non-correlated asset classes that could provide the highest returns with the least amount of volatility.

If you are still looking to diversify within equity, do not go in for stocks of more companies than you can track regularly. Seven to 10 would be ideal, though, of course, this is a highly individual call. The biggest disadvantage of holding a large number of stocks is failing to quit at the right time.