Lessons from 2008

Five mistakes that you should not repeat in the coming year.

For many investors, 2008 was a nightmare that came true. After four years of boom, when the tables turned, it wiped out lakhs of crores of investors' wealth.

Last December, there would have been a smile on everyone's face. While the US had started feeling the pinch of the sub prime crisis, many experts claimed that India was decoupled from what was happening there. Well, it took just one month to change the scenario.

On January 21, in a matter of hours the benchmark indices, Sensex and Nifty, hit the lower circuits. And in the next 11 months, there have been few moments of pleasure for the stock market investor. Both the indices are down over 50 per cent. But depending on portfolio, some investors have even lost 80-85 per cent.

As the year-end approaches, let's look at some of the mistakes that many investors made during the last year and hopefully, refrain from making them again.

OVER LEVERAGING: Buying stocks with borrowed money is leveraging. And it is a crime that many investors committed last year.

Typically, a broker either lends or allows the investor to have a larger position than the money that has been deposited. The interest rate on such lending is higher. Consider this, often an investor has Rs 1 lakh and has positions in the market four to five times of that.

When things are good and stock prices are rising to dizzying levels, everyone is happy. The return on investment outstrips the interest cost. But when the market falls, it is a complete disaster.

For instance, when Reliance Industries was trading at Rs 2,500, you bought stocks worth Rs 4 lakh on an initial capital of Rs 1 lakh. If the stock moves to Rs 2,700, it has gone up by only 8 per cent, but the return on investment (Rs 1 lakh) is 32 per cent.

Now if the stock dips to Rs 2,000, down 20 per cent, you stand to lose 80 per cent. Now if you add the interest cost to the total capital loss, then the initial capital might have been wiped out.

LESSON: Multiplier effect has both sides. Use the loan facility very responsibly and with stringent limits to it.

AVERAGING EFFECT: Whenever stock markets start falling, the initial reaction from investors is to buy more. The idea being that there would be cost averaging.

However, when a slide like this happens, this should be the last thing on your mind. It's because while you may have brought down the acquisition cost, a lot of money has gone into this process. It is almost like throwing good money after bad money.

Often, this happens when one refuses to believe that things are turning sour and the recovery would take a long, long time.

LESSON: Emotional attachment to a stock can be very damaging. If you have made the mistake of buying shares at higher price, don't multiply it by buying them at every low.

INVESTING ON TIPS OR RUMOURS: Many investors can be accused of this one. But things can go real bad sometimes. This is especially true with mid- and-small-cap stocks.

There are hundreds of examples where tips are given for penny stocks or Z category stocks. Initially, it may give you some money. In the long run, however, such investing tactics can be fatal.

LESSON: Just ignore.

DERIVATIVES PLAY: For a lay investor, this is a definite no. As investing guru Warrant Buffet had once said, derivatives are 'financial weapons of mass destruction'.

A large number of small investors used the derivatives route to invest rather than the cash segment. It was easy since futures and options allowed them to take positions on either side (long or short) with little over 20 per cent margin or little option premium.

But since they have to pay only 20 per cent, bigger risks are taken. That is, small losses are not booked. Instead, positions are rolled on in the hope that ultimately things would favour them.

No wonder, losses keep mounting and can really hurt sometimes. For example, it is better to buy futures at Rs 25 and book profits around 25.5 or 26 levels, effectively earning 10-20 per cent return on the margin amount. However, keeping the position open even while losing can be disastrous.

LESSON: Derivatives are not an investment tool but a hedging mechanism. So either don't use it or use only after you equip yourself with its pros and cons.

IPO INVESTMENT: On an average, during boom times, initial public offerings (IPOs) of companies are oversubscribed by 40-50 times. As a result, investors use the IPO route to make quick money.

That is, on the day of listing they simply book profits. For many, it is a sure shot mantra for quick money.

But when the scrip lists lower than the offer price, getting stuck is very much possible. And if someone has taken a loan and applied for the IPO then things could get real bad. Investors who invested using IPO funding facility get hurt the most. Long-term IPO investors may still make a decent return over a long run, but subscribe and sell on first day is out of sight at the moment.

LESSON: Invest in IPOs only when you believe in the company. Otherwise, just stay away.

Investors should realise that making money is a long-term process. However, in their attempt to make a quick buck, many suffer. In 2009, make sure that these mistakes will not be repeated.