How first-time investors lose money in the stock market

Novices should enter markets via SIPs of equity mutual funds, experts tell Sanjay Kumar Singh.
Illustration: Uttam Ghosh/Rediff.com

Valuations in the equity markets are currently at elevated levels, with most indices trading above their five-year averages and close to peak levels.

Meanwhile, about 2.4 million new investors opened demat accounts in 2016, the highest since 2008, according to data from the depositories.

Thus, not only are investors entering equities through the mutual fund-Systematic Investment Plan (SIP) route, they are also venturing directly into stocks.

But direct investing is fraught with risks, more so when valuations are at such high levels.

If they experience losses in their very first foray, they could get turned off equities for a long time, thereby depriving themselves of the wealth-creating potential of this asset class.

Wrong expectations, incorrect approach

Most newcomers enter the stock markets without fully understanding the risks of this asset class.

"They typically enter when the markets are doing well. The moment there is a downturn, they discover that they don't have the appetite for such volatility and exit at a loss," says Mumbai financial planner Arnav Pandya.

Most first-timers also have a very short investment horizon and expect to make quick gains, an approach that inevitably leads to failure.

First-timers also begin to invest in stocks without acquiring even basic knowledge of the fundamentals of investing.

Some set themselves up for failure by engaging in day trading. Others invest based on tips.

"When they don't do their own analysis, they don't have high conviction in the stocks they bet on. They invest small amounts in each stock and over time collect too many stocks, which they are not able to monitor properly," says S G Raja Sekharan, who teaches Wealth Management at Bengaluru's Christ University.

Also, lacking conviction in their holdings, they exit whenever the markets witness their first downturn.

Most new investors also don't understand the usually inverse relationship between high valuations and future returns.

"The probability of earning good returns diminishes as valuations get stretched in a bullish market," says Nirmalya Barua, a Bengaluru investor who had burnt his fingers in 2007-2008, and then taught himself fundamentals-based investing by reading investment classics.

Egged on by their brokers, many also invest in derivatives.

"New investors think they can leverage their money to earn high returns in the derivatives segment. They don't use it as a hedge, as professionals do," says R Balakrishnan, an independent analyst.

Novice investors also have the wrong expectations about returns.

Instead of expecting 12 to 13 per cent in a year, they consider 20 per cent in a day as their rightful pickings.

A few safeguards

For new investors it is advisable to enter equities via the mutual fund route.

They could begin by investing in exchange traded funds (ETFs) or index funds, which do not require them to even pick the right fund.

By investing in these simple products, they will learn whether they have the stomach for the volatility of stock markets.

Once they have learned how to select the right funds, they may graduate to actively managed funds.

"Begin by investing in large-cap or flexi-cap funds. This will ensure that you have a good experience in the markets," says Alok Agarwala, senior vice-president and head-investment analytics, Bajaj Capital.

He suggests that investors should consult the star ratings offered by fund rating agencies.

Investors should also avoid investing any money in the equity markets which they could need within the next 5 to 7 years.

"If they invest money that they are going to need after two or three years, they are placing themselves at the mercy of the markets," says Balakrishnan.

Before entering, investors should also prepare themselves emotionally for long periods when their investments could show negative returns.

They should even be prepared for permanent loss of capital.

Only that amount should be invested which, if lost, will not put them in financial distress.

While investing in mutual funds, investors should make the effort to learn how to do fundamentals-based stock investing.

The direct equity route is only for those who have the time, interest and inclination to research stocks.

Begin by investing small sums and scale up investments as you gain expertise and confidence.

Pointers for curtailing risk

New investors should initially stick to bluechip stocks.

About 12 to 13 per cent of the total market cap of stock exchanges is held by retail investors.

"Of this 12 to 13 per cent, 60 to 70 per cent is in mid- and small-cap stocks. While these stocks do have the potential to give higher returns, that only happens if you pick the right stocks. Make the wrong choices and you could sustain big losses," says Manoj Nagpal, chief executive officer, Outlook Asia Capital.

The novice investor should also steer clear of companies and sectors whose business model s/he does not understand. S/he will, for instance, be better off investing in simple, consumption-oriented stocks, rather than in banking, whose dynamics may be more difficult to comprehend.

Investors should also avoid high-debt businesses.

"Most stocks that take a big tumble tend to be of highly-leveraged companies. Do look at the debt:equity ratio of a company," says Ashutosh Wakhare, managing director, Money Bee Institute, which conducts investor education programmes.

New investors should from the outset have a strategy for the kind of portfolio they plan to build.

"Have enough stocks in the portfolio to ensure adequate diversification, but not so many that you can't monitor them. Also diversify across sectors and market caps, and make sure you have a balanced mix of value and growth stocks," says Nagpal.

Balakrishnan advises that new investors should maintain a diary where they should put down their reasons for investing in a stock.

They should conduct periodic reviews to find out if their investment thesis is panning out as expected. He adds that investors should also set price targets at which they should review whether to stay put or exit.

They should also set a stop-loss level: if the price tumbles below it, they should cut their losses and exit.

Finally, direct investors should be mindful of valuations.

"Many investors get a monthly salary and feel compelled to invest. But if they are investing directly, they should wait for dips. Doing so will greatly augment their long-term returns," says Raja Sekharan.