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Are your investments safe? 5 basic tips

July 09, 2009 16:43 IST

The current financial crisis, which first surfaced in early 2007 in the US, opened up a whole new world of global risk. Though international influence is not a completely new phenomenon, its effects on Indian markets till now were largely muted. In the past, we reacted to movement in prices of commodities like crude oil, but were insulated from several other problems.

Global risks. The excesses in the realty market in the developed world, especially the US, took a toll on the entire global financial system. The rising foreclosures in New York started affecting stock portfolios in New Delhi. As banks failed on Wall Street, there was a stampede to sell stocks on Dalal Street.

Just before the mayhem, the Indian stockmarkets witnessed their biggest-ever bull run - the growth of the economy was impressive and markets were on top of global fund managers' agenda. As money kept flowing and stocks kept moving up, the risk appetite of investors kept rising.

However, once the global flow of capital reversed, money mangers pulled out of Indian markets to cover losses in their home markets, leading to a sharp decline in prices. As the dream run of the Indian stockmarket of over three years came to a grinding halt, Indian investors became exposed to major global macroeconomic risks.

What we faced. The emergence of the current crisis was largely due to undiversifiable risk, which is related to the market. For example, the demise of Lehman Brothers in the US created havoc in markets across the world. Thankfully, the US government stepped in and rescued some of the biggest financial institutions after that.

If financial institutions such as AIG or Citigroup had been allowed to fail, things would have been much worse and the world may have even ended up in a situation akin to the Great Depression of the 1930s.

What should investors do?

In order to maximise gains, investors need to take into consideration macroeconomic indicators like the economic growth projections, inflation, interest rates and commodity prices. Apart from these, following some time-tested market tenets also helps. We list some of the basics that can lead to more successful investing.

Asset allocation. This allows investors to buy when markets are low and sell when prices are high.

Avoid the growth trap. When the markets are on the upward trajectory, experts classify stocks with high valuations as growth stocks. In bull markets, most new offers carry this tag. Always keep an eye on the stock price and see if the company can match its earnings with its valuations. So, if the company is trading at 40 times earnings, you need to judge whether it will be able to grow 40 per cent over a period of time.

It is also important to see the capital structure of the company. Generally, companies in the infrastructure sector, a growth sector, have high levels of debt due to the capital-intensive nature of the business. During a sudden downturn, companies with high levels of debt may find it difficult to service it. During the current downturn, a couple of real estate companies had to sell assets to service their debt.

Avoid impulsive buying. It is very easy to get swept along by the tide, but you should not invest or commit extra resources just because everybody else is doing so. Also, you should not compromise your long-term goals and should cap your equity exposure according to your risk profile.

If you put money in equities, make sure you won't need it in the short term. In the short term, markets can be irrational and can move in any direction. So, long-term instruments like shares should not be bought with short-term money. Also, never ever borrow to trade in stocks.

Get the basics right. It is extremely important to understand the business of a company, its capital structure, its recent performance, dividends, cash flows and the price at which its stocks is available. If you don't understand the business, it will be difficult for you to take a call when prices move in either direction.

7 must-ask questions

  • Are trading volumes high? Low volumes make exit difficult in bad markets
  • Are disclosures adequate? Find out how the company's information sources explain recent developments
  • Is the operating profit figure assuring? Expenses such as new plants sound exciting, but can be risky
  • Are earnings cyclical? You may enter the stock at the wrong time. Once the cycle is reversed, it becomes difficult to get out
  • Is the company highly leveraged? High debt can be risky in cyclical stocks. Profits may drop, but interest outflows are the same
  • Does low PE translate into a bargain? Check the earnings quality, capital structure, recent performance and prospects of low-PE stocks
  • Is the growth sustainable? Before buying, ask yourself whether the company can grow at the rate that the market is projecting¬†

Also, sometimes companies, especially the new ones, are able to show accounting profits, but are not in a position to generate cash. These companies may require more capital infusion at a later stage. If this capital is raised by equity, it will dilute the earnings. If it is raised by debt, it will increase the interest payments and introduce other risks.

Price is another important factor. A company's stock can be a good investment at 10 times earnings and may not be a good idea at 30 times earnings. Stocks bought at higher prices can affect returns in the long run.

Winning on emotions. It has been proved time and again that human emotions are one of the biggest hurdles between an investor and success. An individual who is happy with 6-7 per cent return in debt instruments expects his money to double in the stockmarkets in a couple of months.

In order to do this, he starts taking excessive risk and ends up paying a heavy price. Similarly, when markets fall, people are too scared to enter for the fear of losing money. However, conventional wisdom says that you should be buying when everybody else is selling and vice-versa.

Also, you should not be shy of booking losses. You could make wrong calls, but there is no harm in accepting mistakes. Ideally, you should not hold stocks that you won't buy. On the contrary, people tend to sell winning stocks and keep the losers with the hope that it will recover some day. The current rally in the market is the perfect opportunity to get rid of dud stocks and reinvest in more fundamentally strong companies.

The storm is hopefully past and the financial environment is now giving investors a chance to correct past mistakes and take control of their equity portfolio.

Common myths busted

Myth Equity investing is like gambling

Reality Share prices tend to reflect the shareholder value created. Gambling creates no value - it's the same money to be won or lost

Myth Prices going up will come down

Reality Markets may be volatile in the short tem, but if you have picked up the shares of a company with sound fundamentals at the right price, there is very little chance that you will lose money in the long run

Myth Extra risk makes extra money

Reality Investors should not get carried away by the momentum, portfolio should be well diversified and have a mix of sectors. Avoid leveraging

Myth Stockmarkets are for making quick money

Reality A rising market attracts short-term money, which would not have come to it otherwise, but when the cycle reverses, short-term money exits, with lay investors suffering the most

Rajesh Kumar, Outlook Money
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