Classroom | Putting your money to work (Equity: Part 27)

Having said that, investors, including many successful ones, can fall prey to overconfidence, which could result in a misplaced conviction.

Because of this, usually, the more prudent way to buy a stock is to dip your toes in and put some money to work and watch the price movement afterwards before deciding to further invest.

This strategy further comes in handy when you buy a stock that is in a clear downtrend but is looking cheap. In such cases, you could deploy some capital first before making a bigger bet once you are clear the downtrend has reversed.

When buying a stock following a downtrend reversal, some investors also use technical analysis to time their entry (even if their actual investment thesis is fundamental in nature). In such cases, too, they would buy a small amount first and more later following confirmation of further technical signals.

Ok, I did buy at one go. The stock started falling since and suddenly now, I am not feeling so confident about my idea. What do I do?

The first step is to see whether the fundamentals have changed. Has any new information come to light that could significantly alter the company’s outlook? If you were convinced about the stock when the price was Rs 100, there is no reason why should not be buying more if the fundamentals of the company are still the same, and the stock is now available for Rs 80. Often, stocks of even well-performing companies decline when the overall market trend is bearish.

So should I stay put in the stock or buy more to take advantage of the price decline?

Again depends on your conviction level. If you are quite sure that the market is wrong and you are right, you could add more. This could also be your chance to lower your average purchase price, which could work out in your favour should the stock go back up.

But if something has fundamentally changed for the company and that has caused the stock price to decline, you need to recheck your assumptions about the company and see if it makes sense to buy at that price.

Do remember that once you buy at a particular price, the level also tends to gets “anchored” in your mind. So many investors will buy at Rs 100 and will decide to sell only once the price goes back to the same level, despite the fact that the market does not care about your purchase price.

Here’s a quick mental exercise to judge whether your decision making is clouded by emotional biases. Assume the stock has fallen after your purchase following some news that you’re not sure how to interpret. If you hadn’t purchased the stock previously, would you have been comfortable buying it now at its current price? If the answer is no, sell your stock.

So averaging when the stock price falls seems to sometimes make sense. What about buying more shares if the price rises after you have bought the stock?

Think about what has caused the price to increase. Does it look like a random movement or do the company’s fundamentals seem to be improving? Has the company bagged a lucrative order or posted an improved set of earnings since you purchased?

Now let’s think through both scenarios and weigh them in light of different investing methodologies.

Scenario 1 (random movement/in line with the market sentiment): If you take a more proactive approach to portfolio construction, your bias should start inching towards reducing/selling the stock rather than buying more as the upside opportunity starts getting limited. The more patient and long-term investor would, however, rather not care about short-term movements, with the full knowledge that the recent gains could dissipate as quickly as they were made.

Scenario 2 (visible improvement in fundamentals):

If the company seems to be doing much better than what it was doing when you first bought the stock, you should be buying more of the stock.
Pay heed also to whether the nature of the business is cyclical or one of secular growth. Companies that are less sensitive to the overall business cycle (think consumer or pharma companies, or even IT companies or banks) tend to keep growing consistently. This typically results in the stock compounding steadily. Assuming the stock meets your other parameters, you should keep buying it even if keeps inching higher.

On the contrary, a cyclical stock (say engineering or infrastructure companies) could grow very fast during an economic boom while suffering more during a downturn. For such stocks, the higher they go, the greater the risk of reversion to mean.

Market experts say don’t try to time the market. What do they mean by that?

“Buy low and sell high”. Isn’t that the primary goal for every single investor and trader in the world, expert and novice alike? But in reality, the opposite of this happens more often. Go back and check flows data into the stock market in a year when stocks peaked out and compare it to when they reversed. 1991 and 1992. 1999 and 2000. 2007 and 2008. Inflows in the first year and outflows in the second. Investors bought when they should have sold and vice versa.

It is nearly impossible for most investors to consistently spot when a stock (or the market) has peaked or bottomed out.

Translated into investment terms, this means that when you spot an opportunity that looks good enough to you, you buy irrespective of where the market is.

Is it a good idea to buy a stock just because a high profile investor or a mutual fund has bought that stock?

The reason why many retail investors try to ape high profile investors or fund managers is the assumption that those investors would have done their homework before betting large sums on a particular stock. That could well be the case. But this strategy has several risks.

You don’t know whether the investor you are copying is good, whether their stock idea is good, and whether their risk appetite and investment horizon match yours. Plus, you won’t know what to do if the idea does not pan out.
Think about it: the high-profile investor may have many stocks in their portfolio. Do you? He or she can take a Rs 10 crore loss with the investment. Can you take a Rs 1 lakh loss? They may have purchased the stock with the assumption that they can ride out a 20 percent downside or they may have a very long-term view. Can you feel the same way? Finally, you may also not come to know in a timely manner when the investor has sold.

To be sure, some famous investors such as Mohnish Pabrai profess to use “cloning” as an investment strategy. But cloning is not the same thing as blindly copying, and Pabrai says he first looks at stock picks of other investors such as Warren Buffett and invests in the ideas that he agrees with.

To extend the above logic, should I sell a particular stock just because a high profile investor or a mutual fund has sold that stock?

There is a risk if you adopt/blindly copy an investment idea. If you had bought the stock just following some big-name investor, it makes sense to exit if that investor is selling out. Else, try to find the reason for that investor or mutual fund selling the stock.

It need not always be that the investor has turned bearish on the prospects of the company. It could also be because of an urgent need for funds, or because he feels there are better returns to be made in some other stock or because the investor may have had a fallout with the management. There are plenty of instances where big investors sold a stock because they felt it was overvalued, but the stock price appreciated quite a bit after their exit.

How do I know what is a good time to sell?

Nobody can claim to be an expert at that, not even the best of investors or traders.

Everybody has their own approach.

Some experts advise to set a price target for yourself, and when the stock hits that price, stick to your plan. Discipline helps. There is a saying in the market that nobody went broke by booking profits. Of course, most professional investors and traders will disagree with this. Majority of them follow the policy of ‘cut your losses and let your winners run’. In other words, sell the stocks that are not making a profit for you and hold on to your profitable ones.

Both the above approaches have their merits and demerits. But, it makes sense to sell a part of your holding when it is obvious that the stock is horribly overvalued. Of course, overvaluation and undervaluation are relative. But you will have a fair idea if the price is out of whack with reality. The company may be well managed and in a good line of business, but stock prices never rise in a straight line.