An oath for the amnesiac investor

Published in The Hindu - Sunday Magazine on May 31, 2009

With the stock-market surge having erased all memories of the recent crash, the best prescription for amnesiac investors is an oath to not make the ‘same’ mistakes this time.

It’s hardly been a few months since the market hit rock bottom, when papa bear - Shankar Sharma cooed on CNBC that he would not be surprised if the Sensex plunged to 5000. But now that the UPA is back – Voila! Our economy is going to instantly recover with the tap of a magic wand. Just that instead of a fairy godmother, we are counting on ‘politicians’ this time.

The market crash of 2008 has already faded into a distant haze and so have the lessons learnt (if at all there were any). Chartists are rife with predictions about Sensex hitting 18000 this year and our own Shankar Sharma now says he would not be surprised if the market rises by 40% in the near term.

If you ask me what the economy or the sensex will do this year – the answer would be ‘I don’t have a clue’. What I do know are 1) Economies don’t improve overnight; they grow over the long term but in cycles 2) Over time, a wise investor can clock-in at least twice the annual returns from Bank FD by investing in stocks, provided he doesn’t forget the ‘cardinal’ rules.

Here is an oath for over-exuberant investors who have already forgotten the pain caused by mistakes of the past:

I will reduce my exposure to equities when the numbers point to a bubble
It is dangerous to remain fully invested in an expensive market. One can easily verify how expensive the market is by checking the P/E (price to earnings ratio) of the Index at: http://www.nseindia.com/content/indices/ind_pepbyield.htm

History has shown that whenever the P/E of the Index rises over 22, we are in for trouble. So resist buying at such levels and try to reduce your overall holding in equities to be on the safe side.

I will not be seduced by trends
It’s tempting for our brains to observe a high growth rate and then simply extrapolate this trend into the future, like what we did with real estate stocks. This has proved to be fatal, time and again. A fine example is the stock price of Infosys in year 2000, when it was trading at a price equivalent to 350 times the annual earnings per share, with high hopes that the company will continue to grow its earnings at nearly 100% p.a. But we all know what happened, earnings did grow but not as high as expectations and today this excellent company is available at pretty much the same price as it was 9 years back.

I will not salivate over companies making mega-acquisitions
Acquisitions take many years to work and many of them fail. Buying a stock just because the company has made an acquisition is foolish. While synergies are easy to quantify on paper, realizing them is an entirely different ball game. What one must stay away from are companies acquiring firms larger than themselves, by paying ‘cash’ and that too borrowed from the bank! That’s a potential triple whammy.

I will depend on ‘margin of safety’ to protect myself
The case for investment in a stock is based on the future performance of the company. But as we have seen it’s hard to predict future performance. So the ways to hedge your bet are: A) never invest 100% of your cash reserve in stocks B) buy stocks at minimum 30% discount to the conservatively estimated intrinsic value.

I will not borrow to invest in stocks or invest in companies that have too much borrowing
Investors and promoters who borrowed too much are either forced to liquidate their assets at dirt-cheap prices or stuck with loans worth much more than the value of underlying investments. Don’t borrow money to buy stocks and avoid investing in highly indebted companies (companies with > 25% debt/ total capital).

I will not take advice from salesmen
Most people hesitate to pay for independent financial advice and as a result settle for advice from brokers (or other agents) without realizing that there is an inherent conflict of interest because brokers earn a commission based on how much one invests, irrespective of the performance of one’s investment.

I will not speculate in IPOs
Companies offer shares for sale in the public-market only when people are willing to pay extraordinary prices. That is why you witness maximum IPO activity during bull market frenzy and not in bear markets. There are many opportunities to buy stocks cheap; the IPO is not one among them.

I will not use astrology to decide where to invest my money
Hundreds of academic studies demonstrate that no technical strategy can over the long term beat the simple technique of buying and holding on to an Index Fund. Yet, people are hypnotized looking at charts.

I will not blindly follow FIIs
During the hay days of 2007, private placement of shares by a company to FIIs would immediately take its share price to stratospheric levels. Today, many of the same stocks are available for a fraction of the price. Surely FII investment could be a vote of confidence for owning a stock, but not a reason to own it at any price.

I will learn some fundamentals before investing
All of us work hard to earn our pay. But when it comes to investing the money we have earned, we choose not to spend even a fraction of the time. If you think your money is valuable, it is your moral responsibility to acquire at least the basic knowledge required for making and monitoring investments.