Stock market investment: How to ride with the tide
The primary objective of this writing is to focus on some investment strategies and common investment mistakes and to put forward some common prescriptions for all types of investors
The stock market globally offers lucrative risk-adjusted returns for prudent investors. However, getting the best bet in the world of stock screening is not as easy as it sounds.
The Bangladesh capital market is primarily an equity dominated market. The business of stock investment involves both art and science.
Anybody who is planning to start investing should get some preliminary understanding of the capital market. He should have a defined investment plan and set strategies before getting into the battle.
A novice investor should initially define his/her personalised investment style, investment horizon, target return, and risk tolerance, etc. Besides, a good investment in stocks also involves numerous calculations, data collection, and data processing.
Understanding human behaviour is also one of the most crucial factors to achieve superior returns in this market as Morgan Housel stated in his book titled The Psychology of Money, 'Financial success is not hard science. It's a soft skill, where how you behave is more important than what you know.'
I personally view the stock market momentum as like that of a river where sometimes we have to swim with the tide while sometimes against the tide. The market may experience a prolonged bearish streak and dry situation due to severe illiquidity.
However, it will definitely revive someday and passionate investors will be rewarded most in such times. However, investment in the capital market is also associated with significant risk and uncertainties as different tailwinds and headwinds come several times.
Sometimes, you might be able to generate hefty returns while other times you may have to incur stormy losses that might take away everything, if you fail to take the right decision at the right time. So in the capital market, there is no end to learning.
A good understanding of the capital market is not an easy task and even professional fund managers also have bitter experiences and most of them fail to beat the market steadily. For any fresh investor, it is important to look at the broad market performance and outlook.
Ideally, technical analysis, which deals with price and volume patterns, sometimes provides a good short-term indication of support and resistance level for the broad market performance and aids in identifying the right entry and exit point from the market.
The technical analysis reflects the overall investor's behaviour, sentiment, and expectations within its patterns. Reviewing fundamental factors indicates the long-term market outlook, i.e., whether the market is cheap or expensive.
However, not every investor has the access to such sophisticated analytical tools and skills or access to expert analysts. Hence, an ideal investor needs to be very cautious and smarter when the market takes the bearish drive and starts to fall.
In a bull market, it is comparatively easier to pick a comparatively good stock without even diving deep. Anybody can become a good analyst or predictor at the early stage of a new bull run as it is easier to predict potential rally in severely undervalued stocks.
But, picking the right investments and finding the right entry and exit prices in a stable or falling market is not an easy task for everyone. Every investor needs to be cautious about the entry and exit point in the market. Even the best stocks can perform extremely poorly when the broad market falls sharply.
My primary objective of this writing is to focus on some investment strategies and common investment mistakes and here I have put forward some common prescriptions for all types of investors, from novice to experienced, for any market situation.
There are some very common areas where the majority of the investors do make mistakes. The first mistake is failing to make the optimal trade-off between risk-free (or low-risk) savings and risky investment.
One should never put all his eggs in one basket. Hence, one should never invest part of his income or savings that are required to meet monthly family expenditures such as education and housing expenses, etc.
Besides, one also needs to set aside some money in comparatively liquid forms for unpredictable future emergencies such as medical costs for the family. Investments should be fairly diversified between liquid (such as equities & fixed income components) and non-liquid assets (such as Real-Estate).
Fixed income components such as Bank Deposits (FDR, DPS, Bonds), National Savings Certificates yield comparatively low or moderate returns but at significantly low or even at zero risks while investing in equities and mutual funds are categorised as highly risky but can also yield significantly higher returns.
A risk-averse investor can prefer to invest a larger part of his equity investments in fundamental or blue-chip stocks that can generate moderate attractive returns with comparatively lower risks while a risk lover may choose to invest a higher portion in low-fundamental or junk stocks, trading only based on market intelligence, that may yield high returns but at a significantly higher risk.
An optimal trade-off between risk and reward is a prerequisite based on investors category to protect investments from the unfavourable winds. A typical investor can allocate one-third of his investments in cash and fixed income liquid investments (such as bank deposits), one-third in stocks, and the remaining one-third in low liquid or other risky investments (such as real-estate).
Investing in stocks without knowing anything about the company is also a big but common mistake. Investment in stocks should always be considered as similar to that of any physical investments where someone is putting part of his valuable money to the other party after sufficient scrutiny.
Likewise, any stock investor also needs to do a little bit of research before investing in stocks. There is nothing to be scared of the word 'research' and no one is required to go for complex valuation methodologies, calculations, and analysis, etc.
There are certain factors that one should consider before investing to remain protected from unbearable downsides. One can primarily look at the sector the company operates in before proceeding further.
For example, is it the right time to invest in any construction (cement/ steel) stocks or pharma stocks? Can companies in consumer goods generate higher returns than that of the financial sector stocks?
However, after picking a company to invest in from a chosen sector, one must look at some very basic parameters such as who are the majority owners of the company? Who is representing the board? Is the management team capable enough to run the company?
Do they have good corporate governance practices in place? Are the financial reports reliable and is there any history of earnings management, high earnings volatility, or unpredictability?
Are there any significant doubtful intercompany transactions (some companies may sometimes conduct some transactions that are beneficial to other group companies where directors have majority ownership but at the cost of the listed companies, cheating with the minority investors)?
And finally, can you trust them to provide your hard-earned money? Investors also need to know about the growth pattern of the company's earnings and profitability, can look at the price-earnings ratios, any legitimate expansion plans in hand, and future business prospects.
Besides one may further look at some additional factors such as companies with a lower level of debt are superior to higher debt-based companies as interest expenses eat up a significant portion of the operating profits.
Furthermore, companies focused on a single line of business are ideally better than the conglomerates as over-diversification eats up a significant part of the profitability whereas investors themselves do have the opportunity to create their own well-diversified portfolios by just investing in several non-related diversified stocks.
Finally, after making an appropriate investment decision, risk management is another area where only prudent investors can beat the market identifying various stages of the life cycle. When a new market rally begins, there generates huge optimism and excitement among the mass investors as soon as the market gets higher media attention.
For example, when the Bangladesh stock market started to revive in July 2020 after a prolonged bearish streak, investors participation started to increase gradually in line with greater media coverage and the broad index rose to as high as 5909 points in January 2021 and average daily turnover during the same month increased to BDT 16,171 million whereas the broad index level was as low as 3604 points and average daily market turnover was only BDT 3,692 million in March 2020.
As the bull run continues, investors become greedy and over-confident and they start to take maximum financial risks as the market reaches its peak. However, as soon as the market begins to fall, they become concerned, even though they defend themselves by arguing that they are a wise long-term investor!
However, as the market continues to witness free-fall, fear grows and with the continuation of the bearish trend, panicky investors start to liquidate their positions and brokers also initiate force sales on margin codes to protect their funds and ultimately at one point of time the market reaches the point of maximum financial opportunity. Again, as the market starts to show signs of recovery and when a new rally gets its confirmation, depression turns into new hope and new optimism arises.
At the early stage of a new rally, only smart monies are being injected by opportunity hunting investors while during the later phase, knowledgeable investors (such as institutions and HNIs who have access to timely funds and the capacity to afford sufficient research) enters the market while most of the retail investors enter in the later phase when the market gets huge media attention. So, to beat the market and protect from the losses in a falling market scenario, any investor should make some check and balance on some common big mistakes regarding the investment decisions.
In a falling market, getting anchored to a price (a target sell price or cost price) with the hope that prices will revert to that level in near future without properly assessing fundamental reasons behind the price fall, may only extend the losses further. The share prices may drop for several reasons affecting the valuation of the company and in such cases, it is wiser to cut losses and exit.
Furthermore, getting caught in the value trap can be another identical investment mistake. Sometimes some stock prices look very attractive because their prices have fallen sharply but in actual cases, their prices may continue to remain low for a long period.
Similarly, buying at 52 weeks low level may also not always turn into a good idea, even though it may signal a potential bottom level. Sometimes stock fundamentals may deteriorate significantly or the market even may remain irrational for a much longer time frame and prices may drop further.
Another common big mistake is buying more to average which may compound the losses further. Generally, averaging down is a good idea to cover losses when the stock fundamental is strong and the price decline is temporary. However, if the company fundamentals deteriorate or the broad market takes a long downtrend, averaging down will only multiply the losses.
Falling for confirmation bias is also one of the common mistakes. In a falling market, investors put a value on information and signals that support their beliefs while tend to ignore information or signals that oppose their beliefs.
Furthermore, taking leveraged bets can also lead to big losses. No one should play with money that he can not afford. Leverages can multiply one's return when everything goes well. However, due to a high degree of uncertainty, a rational investor should never invest with margin as any unfavourable price turn can lead to force closure of the position.
Some other common mistakes that can also exaggerate the losses further in the falling market or limit the profit potentials are a sudden change in the investment plans and long-term strategy, failure to deal with emotions and excitements and becoming impatience, over-diversification of the stock portfolio, falling in love with specified company stocks, attempting to time the market or trying to catch the bottom, etc.
However, one does not always need to follow all the above-mentioned strategies but the more one can follow the higher his stock investments will remain secure. But what if, for any investor, all the above issues look very difficult or clumsy or he does not have the time, energy, or required financial skills to go through the said investment strategies?
The door for stock investment is still open for him. A professional fund manager or a well-managed open-end mutual fund can be a good solution (where trading will be based on the NAV per unit) and they will do all the required jobs for him. Still, choosing the right investment manager or a good governed, good performing and well-managed mutual funds also require some knowledge and market research.
Looking at the available portfolios of funds can provide an idea of the respective asset managers' investment styles. Besides, mimicking the portfolio allocation of stock investments by some well-managed funds with a history of good performance can also be a good idea for making safe self-investment for any busy investor.
Mohammad Asrarul Haque is an Equity Research Analyst at a leading stock brokerage house and can be reached at [email protected].
Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.
