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You are Here : Investing Logic FAQs

Q. Why you should not be investing just to avoid tax?

A. Investments are made to achieve financial goals in future. An investment is expected to earn an estimated rate of return which will help you pay for your needs in future. Hence your investments should be purely based on factors such as your financial goals, your risk profile and time in hand.

An investment can always help you to save tax. For example, an investment in tax saving bank fixed deposit fetches you a tax deduction up to Rs 1.5 lakh under section 80C of Income Tax Act. However that should not be the sole criterion to invest. Consider a situation- Suresh is in his early thirties and has no financial liabilities. He intends to save for his retirement which is due 25 years from now. He should ideally be taking a bit more risk and investing in equities. Equity mutual funds and not fixed deposits is a better prescription for his financial goal of retirement. If keen to save on tax, he should ideally be in tax saving mutual funds and other diversified equity funds.

Also, the attitude of investing for the sole purpose of saving tax makes many individuals myopic. Investments have to be done regularly. But when one joins the 'tax saving' band-wagon, he invariably ends up investing in last week of March, and in many cases, ends up buying something that does not serve his long term financial goals.

Better take all round view of your finances while investing. Tax can be one of the parameters of the checklist you use while investing, not the sole parameter.

Q. Why you should prefer to average up than average down?

A. Averaging or buying more is a typical action most traders and investors undertake when they trade or invest. Averaging down means buying more when the stock is going down contrary to expectations and averaging up means buying more when the stock is going up in the desire direction. Let us understand this with relevant examples.

Suresh bought shares of XYZ company at Rs 100 with a view that the price will touch Rs 125 in a month. However, soon after his purchase the stock tumbled to Rs 98, so he added more to his kitty. The stock further went down to Rs 95 and he bought more. Here he is said to be averaging down.

Ramesh bought shares of PQR company at Rs 100 with a view that the price will touch Rs 130 in a month. Soon the stock hit Rs 105 mark and he bought more and he further added to his position when the stock crossed Rs 107 mark. He is averaging up in his trade, says the market jargon.

The logic offered by a trader who is averaging down is that the average cost of the holding goes down and the trader makes big profit when the price gains. However, an attempt to average down can be a loser's game. When the stock price moves contrary to expectation, the trader may have got his analysis wrong. A call that has gone wrong can further wipe out trader's capital. The hope that the price will rebound make many traders add to their losing position which further aggravates overall losses if the price does not respond favourably.

Hence market wisdom says that one should further add to the winning positions. If a trader is making money in a trade, it makes sense to add more to that position. If he has bought a share and the share is in bullish phase, he should ideally buy more than feeding capital to a loss making position.

The old adage of cut your losses and let your profits run is to be kept in mind when one trades.

Q. Why a stock hitting 52 week low does not necessarily make an attractive buy?

A. It is a dream of every investor to buy low and sell high. Where do you see a stock available low? - Obvious answer to this question is to go for list of stocks quoting at 52 week low. Exchanges and media both are quick to offer this list which makes it a low hanging fruit for many. But the reality can be way different. One may not necessarily get a good 'buying opportunity' when he is looking at a stock quoting at 52 week low.

To understand the risk one is exposed to when he buys a stock just because it is quoting at 52 week low, we should understand how the 52 week low stock list is made. When a stock's current price is lowest as compared to the prices it has quoted over last one year, the stock is included in this list. However that does not mean the downside in the stock is over. The stock price can tumble further the next day and it will again appear in the 52 week low list for that day. A stock in downward trend will keep appearing in the 52 week low list for many days. And one may not make any money buying a stock which is moving down because the business fundamentals of the company are ruined.

Classic example of this is the downfall in technology stocks post dot com bust. The stocks were in downtrend for months and ruled 52 week low list for long period of time, before disappearing from the trading screens. If one would have bought into one such name just because it is quoting at one year low, he would have lost his capital.

Technical analysts treat a stock hitting a new low as an opportunity to further sell that stock, as the stock quoting at new low confirms continuation of bearish phase. Fundamental analysts do look at stocks quoting at low prices, but they seldom buy them. The buy action in stocks quoting at 52 week low by a fundamental analyst, is generally backed by solid analysis of the business fundamentals of the company. Hence it pays not to solely rely on 52 week low price as a good buying price for a stock.

Q. Why you should not chase penny stocks?

A. It is tempting to buy 1000 shares of a stock that is quoting at Rs 3 than to buy one share which is quoting at Rs 3000. For some the thrill of buying hundreds of shares (large quantity) pushes them to buy a penny stock - a stock quoting at an absolute low price. For some Rs 3 is very cheap and accessible whereas Rs 3000 is too costly to buy. Whatever be the reasons, many individuals are seen chasing the next Infosys and next Larsen & Toubro. However, chasing penny stocks just because they are quoting in single digits may not be a wise idea.

The first logical reason is - a stock that has done well and is expected to do well is preferred by most investors which is why it quotes at 'high' price whereas shares of a company that has not done well and may not have a great future languish at low levels. No wonder penny stocks in most cases disappear from the trading screens than making it to the top – it is an unwritten law of the market. It is not necessary that the story you heard of someone buying thousands of shares of a stock at Rs 8 and then selling it at Rs 1000 has to be false. But it is the exception that proves the law.

The second reason why a penny stock may not be cheap as compared to a high priced stock is the price it commands may not be true representative of the underlying value. For example, a company which has gone bankrupt may have its shares trading at Rs 5, when in reality the value of these shares may be closer to zero. A company that is doing extremely well and growing 30% year on year will see the stock prices zooming over a period of time. A share quoting in thousands - say Rs 5000, may actually worth much more and hence appear on the buy list of most analysts.

If one looks at valuation parameters such as price to earning, price to book value; many penny stocks appear costly, whereas high priced shares may appear much cheaper. For example, a stock quoting at Rs 5 may have earning per share of 5 paise, which boils down to price to earning ratio (P/E) of 100. A stock quoting at Rs 5000 may have earning per share of Rs 100, which means the stock is quoting at P/E of 50. Higher the p/e costlier the share. Put simply, in aforesaid case, share priced at Rs 5000 is actually cheaper than Rs 5 share and may have better prospects too.

Never buy a penny share because it is quoting at low price. Buy one if you know the business prospects - buy value and not the price, says the old wisdom.

Q. Why you should choose investments that contain downside risk while participating in upside?

A. When markets are in bull phase, most investors ask for the best performing stock or the best performing mutual fund scheme. If a scheme has given 100% returns in past year, it is the best bet for them. But in reality one should look at the ability to contain downside as much as the ability to generate returns in the upside.

The old adage says that today's investor does not benefit from yesterday's returns. If an investment has shown good appreciation in the past, that does not make it necessary that it will keep giving similar returns in future. Hence there is no point focusing too much on returns generated by an investment. An investment that has done well in the past, may actually post a loss in future. For example, an individual who invested in January 2008 in equities looking at spectacular returns posted in CY2007, have lost money in CY2008.

Downside cannot be ruled out altogether in financial market, and especially in volatile asset classes such as equity one has to be very careful. Consider this - a stock has fallen to Rs 40 from purchase price of Rs 100. In this case the investor is sitting on a loss of Rs 60 or 60%. Now if he wants to recover the loss, his investment must show a gain of 150% and not 60%. An investment that contains downside helps the investors in bad times. Aforesaid example makes it clear that the required rate of return to recoup losses is higher than the rate of loss. Do look for investments that offer high returns, but do not ignore how they are expected to behave in bad times.

Why you should buy commodities and not commodity companies if you are bullish on commodities?

A. Short cut does not always lead us to our destination, says the old wisdom. Buying shares of a commodity manufacturer is a preferred way to invest in a commodity, prices of which are in uptrend. However, it may not necessarily offer capital appreciation to you, as share price of the commodity manufacturing company need not necessarily rise with the rising price of the commodity it manufactures.

Company may not necessarily be making money on that commodity, as the manufacturing cost of the company may be higher than the market price of the commodity. The company's balance sheet may be over-leveraged, which may make the company to use most of the operating profits to service loans, leaving almost nothing for the shareholders.

There are also instances of companies selling their produce at a subsidized rate due to government policies despite rising prices worldwide in open market. There are instances of companies selling their products to sister concerns at almost no profits or at minimum profits. Corporate governance practices also matter for equity investors. If the promoters siphon off cash, arising out of increased profitability, there is not much left for minority shareholders.

In addition to above, if the broader equity market sentiment is bearish, the shares of the best positioned commodity manufacturer may take time to rise. To overcome all these factors, it is better to own the commodity if you have a bullish view on it, than owning a company that manufacturers that commodity.

Why you should not overtrade?

A. High frequency trading initiated by institutional traders and treasuries may make many individuals consider the idea of frequent trading for small profits per trade. Thereby they may aim to accumulated wealth. However the reality may be exactly opposite of what is expected. Frequent trading has two big disadvantages. First it leads to high transaction costs. Each time you trade, you have to pay brokerage, service tax and exchange fees. This eats into the spread (difference between buy price and sell price) you have. If you do not make any money on a trade, these transaction costs further amplify your losses.

Second big disadvantage is the adverse tax treatment traders face as compared to long term investors. For example, in case of equity investing, capital gains arising out of investments held for more than one year are tax-free in the hands of the investors. However, if one gains from investments or trades held for less than one year, the gains are taxed at the rate of 15.45%. Across asset classes government and other regulatory authorities encourage long term investing.

Due to these factors, other things remaining the same, a patient investor makes more money as compared to one who overtrades. An investor who makes limited number of transactions and has with a mind-set of taking calculated risks, typically emerge wealthier as compared to one who is too active.

Why you should buy a rumour and sell on news?

A. Stock prices climb when there is an expectation of good news and when the good news arrive, there is a sell off that follows. When there is an expectation of bad news, the stock prices typically fall, and when the news hit the markets, stocks actually go up.

This happens due to market participants’ response to expectations - rumours. When there is an expectation build up in the market, the market participants accordingly take their positions. For example, if a company is going to announce a blockbuster project- the traders typically start purchasing the stock from the market much ahead of the actual announcement. This pushes the stock price upwards. Many a time the stock price surges to an extent that the best possible outcome of the project, in terms of possible upside in earnings, is already factored in the stock price.

In such a scenario the traders prefer to offload the stock to the investors who are willing to hold on to the stock for long term to benefit from the improvement in business prospects of the company. The company needs some time to execute the project and the earnings are expected to take some time to materialize. Also there are execution risks associated with projects. Most traders prefer to pass on this risk to the new buyers of the stock and offload their position in a short while. Position built over a period of time, when offloaded in a short time, typically leads to a fall in stock prices.

If the news expected is not the same as expectation - to be precise if the actual project announced is far smaller than what was envisaged, there is a sell-off by traders and the stock prices correct.

Why you should not be mimicking a fund manager?

A. Why pay a fund house to invest in stocks, say some first time investors. When they come to know that the fund house declares its investment portfolio monthly, they think that it is even easier to invest - just buy what the fund manager buys and sell when he sells. However in real world it may not be as easy as it sounds.

There are hundreds of schemes and many successful fund managers. Choosing one of them is a task. Even if you zero on one with good long term track record what if he underperforms for a year or two? Are you going to stick to your decision of mimicking him? To add to your woes, fund managers manage more than one schemes and each scheme's portfolio has around 50 stocks on an average if not more. Can you keep buying and selling so many stocks?

Even doing it at the right price is a problem. Scheme's portfolio is declared at the end of month. Though you know the portfolio at the end of the month, you are not aware of transactions he did and reversed within a month. In case of actively managed funds, this can make a big difference. As you are getting the information with a lag, you cannot buy and sell at the prices the fund manager does.

Transactions costs for the fund are less in percentage terms given the large pool of money it manages. This results in the higher post-cost returns in fund's hand compared to an individual who is carrying out similar transactions with a smaller asset base. With so much difficulty even if one manages to follow a fund manager, it is highly likely that he will have to settle for much lower returns in hands.

Why invest only your surplus funds in equities?

A. In a rising markets many individuals want to bet every rupee on equities. The reasoning for them is very simple - make the most of what they have. However in real life this may back-fire.

Each individual has many financial goals in life. Some of these are long term goals such as retirement, bequeathing wealth to next generation, whereas some are short term goals such as a foreign tour next year, paying school fees of daughter six months from now. Also one may come across urgent need of money due to sudden hospitalization in family, an accident causing financial loss. Insurance may not pay entire expenses in such situation and one may have to pay from his pocket. One must provide for such expenses in short term.

If one uses the money meant for short term financial goals to trade in equities he is exposed to a big risk. What if the markets tank quickly and he suffers major losses? In such a situation, he is will find it difficult to pay for his short term goals. Using short term money for investing in shares, may cause cash flow crunch. It may not only lead to monetary losses but also take away peace of mind. Always invest that money in risky assets such as equities which is left after keeping money aside for short term goals and meeting emergencies.

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