Tuesday, September 28, 2010

Common mistakes made by investors

Stumbled upon this article by Ang Kok Heng, CIO of Philip Capital on The Edge. A good read on common mistakes made by investors.

Reluctant to cut loss
The single biggest mistake of local investors is their reluctance to take losses. This is not unique among local investors but also happens in other countries, including developed markets like the US where investors are believed to be more savvy than those in the emerging markets. A person tends to feel more painful when taking a loss. Research shows that the quantum of pain from suffering a 30% loss is about 2.5 times more than the joy from making a 30% gain. To avoid the pain, investors tend to keep loss-making stocks year after year. So long as the loss-making stocks are not sold, the pain is not felt.

It is not uncommon to see an investor having a long list of loss-making poorer quality stocks in his or her portfolio statement. The excuse given for not selling these stocks is waiting for the stock to recover to their costs. Psychologically, it is believed that so long as a loss-making stock is not sold, there is still a hope that one day the price may recover, but if the stock is sold, the loss is realised.

It is normal to hear: “I am stuck with the stock due to losses”, “how can I sell now, the price is lower than my cost”, “I can’t do anything now as the price has gone down”. As the market does not set any trap to catch punters, it is the punters who voluntarily tie themselves up by refusing to get out of the sticky situation. The stock will not recognise who got “stuck” with losses, neither will it feel sympathy for the loyal punters who have been gruelling in financial pain.

For whatever reason, when a loss-making stock is purchased, the only rationale to continue holding on to the stock is hope. Most of the time there is no specific fundamental reason or news to justify holding on to the stock. Hope is a bad reason for holding on to a stock as the fate is purely determined by chance which may or may not happen.

Unfortunately, if fundamentals continue to deteriorate for some of these poor quality stocks, they may fall under PN17 or be eventually delisted. By then, it will be almost impossible to recover whatever was invested in the stocks. An 80% deterioration in price can end up as a 100% loss when the final nail is hammered into the coffin.

Quick to take profit
Another reason why a typical investor has a long list of loss-making third-liners and little in quality stocks or blue chips in his or her portfolio is that most of those stocks which made money have been sold. As the probability of making money from quality stocks and blue chips is higher, investors are quick to lock in the profit and proclaim a victory.

Over time, good stocks are sold and poorer-grade stocks are kept in the portfolio. Unknowingly, investors sold the valuables and became collectors of “rubbish”.

It is also common to hear “advice” from fellow investors that one should not be too greedy. If a stock appreciates by 20%, common advice is to lock in the profit before the price comes down. It is not entirely wrong to take profit. But what if the stock price falls by 20%? Should there not be a similar strategy to protect a portfolio when the stock price turns south? Investors made several mistakes by taking early profit:

• Taking profit early should apply to trading stocks and not on investment-grade stocks.
• Investors should also set a cut-loss strategy instead of only profit-taking strategy.
• Instead of selling quality stocks and keeping speculative stocks, investors should sell speculative stocks acquired based on rumours and keep quality stocks.

Preferring cheap stocks
When it comes to the level of stock price, the common perception is that a RM1 stock is cheaper than a RM10 stock. It may sound logical but it is entirely wrong based on fundamental of investment. From an investment approach, a stock is purchased because of its future earnings outlook. As such, a RM1 stock having negligible earnings is more “expensive” than a RM10 stock yielding RM1 profit per share.

Perhaps a RM1 stock is perceived to be easier to be “pushed” by syndicates or easier to move up than a heavyweight. Low-priced stocks are generally considered as retail stocks as they normally lack fundamentals and are not popular among institutional investors. Without the help of so-called syndicates, low-priced stocks are traded among retail investors themselves from the same pool of money. There is no fresh money to lift the stock price higher. This is unlike institutional stocks where improved fundamentals attract more money, including foreign funds, resulting in more demand than supply. Hence, investment-grade stocks benefit from the strong price support, leading to a continuous price appreciation over time.

By the same token, when a company announces a bonus issue or split issue, which leads to a lower price level, it is much welcomed by retail investors. On the other hand, when a stock calls for a share consolidation, the price will plunge. Stock consolidation can be due to changing of par value from 20 sen par to RM1 par or due to capital reduction.

When our market was less mature, there were many retail investors who invested based on rumours and speculation. Now, there are fewer retail investors participating in the local market and syndicates are also less visible. The strategy relying on trading penny stocks has not seen much result in recent years. Although there may be some penny stocks which turned into a five-bagger or even a 10-bagger, such incidence is far in between.

Changing the goal post
Another common mistake by local investors is the unclear investment goal and strategy, whereby investment stocks and trading stocks are mixed together. As these stocks have different characteristics, they should be treated separately in terms of investment strategy.

A trading stock is normally purchased on a piece of news or rumour which may or may not happen. An investment-grade stock, on the other hand, is normally purchased based on fundamental reasons such as earnings outlook, business potential, growth prospects, etc.

As a trading stock is more speculative in nature, it should be monitored based on the reliability of the source of information. Technical charts are more useful in helping one time decisions to sell, hold or to buy further.

Sometimes, investors know they are speculating on a stock but when the stock is out-of-the-money (that is in a loss position), they tend to keep the stock as if it is investment grade. A punt on a trading stock for short-term gain with a timeframe of several months may end up as long-term hold for several years. The initial objective to make some quick gain by speculating on a piece of news or rumour may end up in the form of hope that the stock price will recover to the cost.

On the other hand, some investors buy an investment-grade stock for long-term investment due to its strong fundamentals or the dividends. But when the price moves up, some investors are quick to take profit for fear that the price may come down. The irony is that a long-term investment now becomes a short-term trade when early profit is seen.

So long as investors keep changing their goal post and are confused over trading and investment stocks, between short-term speculation and long-term investment, their equity investments will be in a mess.

Excited by tips
Over the years, retail investors have been fond of relying on tips to make money from the stock market. Many who depended on tips have lost so much that they simply left the market and some vowed they would never touch shares again. Trading based on tips may be exciting and experienced investors will confess that it is difficult to make money purely on tips.

What are tips? Tips could be insider news from those who know what is going to happen. Insiders could be companies’ directors and senior management, professionals like corporate lawyers, auditors and bankers who may have some inside information or even reporters, analysts, fund managers and individuals who have access to the senior management of the companies.

Some tips could be true, some may be pure speculation but there are also some which are fabricated by syndicates as part of their game. Most of the time when a punter obtains a tip, it is not first-hand information. The tip could have passed down several hands. In such a case, even if there are changes to the information, punters will be the last to find out. After the share price has plunged, only then will they realise that things have gone sour. By then it could be too late to sell and the stock may be added into their long list of “collector’s items”.

Little homework
Most retail investors do little homework before investing. Even if they have, it is normally very superficial.

There is also little follow-up on the subsequent changes to the fundamentals. Many retail investors give the excuse that the accounts are too complicated to understand. If someone like an analyst has analysed a stock and recommended a buy, the investors will probably rely on the call to make their bet.

Recommendations appearing in newspapers are also one of the main sources of investment ideas.

No patience
Another common weakness of retail investors is their impatience. Most of them want quick gains. After they buy a stock after a recommendation or a tip, they will monitor the stock movement closely. If the stock price moves up, they will praise the person who recommends the stock. But if the stock does not move after several weeks, they will become impatient and keep asking when the stock will move.

Most retail investors are not too keen to invest in a stock that makes 10% per year. They are excited with highly volatile stocks or high beta stocks that can potentially double in value or gain 20% within a week or two.

They always buy higher, sell higher
Because retail investors have little patience, they are not keen to buy on market weakness and wait for the market to recover. The tendency to chase a stock is common among retail investors. As they want to make quick money, they will prefer to buy high and try to sell higher, a strategy more aptly applied in a bull market.

This phenomenon clearly explains why more retail investors appear during a bull market but there is no trace of them at the bottom of the market when prices are much cheaper.

The strategy of buy-high-sell-higher is definitely riskier than buy-low-sell-high. The former strategy is not inappropriate but investors must get out of the market if they are wrong. Unfortunately, cutting loss is too painful for most people and many retail investors eventually get “caught” again.

The lessons
There are many lessons we can learn from the mistakes of retail investors who can be someone close to you, one of your family members, your colleagues, your friends or even yourself. To be a successful investor with an aim to increase wealth, we need to overcome some of the common human weaknesses in investing.

Top of the list, one has to learn to be impartial and view a stock objectively. If a mistake is made and the best thing to do is to take losses and to cut the stock, then it should be done without hesitation. If necessary, a small timeframe is given to try to sell at a slightly higher price. After the timeframe, the loss-making stock must still be axed. If you do not have the discipline to take losses, then trading is not for you.

Investors should be clear about their investment plan. Buy-and-hold investment stocks should be segregated from buy-and-sell trading stocks. As the two stocks have different characteristics, they should be treated separately with different strategy. The worst mistake is to buy a short-term trading stock and eventually keep it as long-term investment stock. In general, investors should learn to cut losses and let the profits on investment-grade stocks run instead of selling all the good stocks and accumulate speculative trading stocks.

Investors who like to dabble on tips should always remember that speculative stocks are trading stocks and a certain timeframe should be given for the “tips” to work, otherwise the stocks should be discarded even at a loss. This is the nature of the game. The bet is either you make or you lose.

Source: The Edge

1 comment:

  1. Many thanks to you for sharing this information.You explained every point very well.
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