What do you do when investments run into the red?

Last Updated: Mon, May 27, 2013 04:36 hrs

The retail investor is usually wrong. Small investors tend to trade too often; they buy at the top of rallies; they sell at the bottom of troughs; they hold on to losses for too long and book profits too soon. These traits seems to hold true to greater or lesser degrees for most markets.

There is also a large degree of churn. Many individuals dabble in equity. After they commit some or all of the above mistakes, they lose some money and exit the stock market. They are replaced by a new batch of investors who follow the same pattern of behaviour.

Some unfortunates commit these errors on a serial basis. That is, they enter and lose some money and exit, vowing never to return. Then they re-enter a few years later and commit the same mistakes all over again.

There is some evidence that a small percentage of retail investors actually learn from their mistakes. They become smarter in terms of getting rid of their losses earlier and holding on to the winners for longer periods.

But a large majority of investors never learn and never make money.

Similar patterns of loss still seem to hold with investors who buy mutual funds rather than direct equities. While funds have different risk-return profiles vis-a-vis direct equity, the principles for sensible long-term investment or trading remain much the same in both cases.

Most important, the investor has to hold winners for the long term.

In India, the average mutual fund investor is blindly following the advice of an agent whose only interest is in generating commissions. So, there is far too much mis-selling and churn in this segment as well.

Very few fund investors commit to the systematic investment route over the long term. Nor do they invest sensibly in a basket of diversified funds.

None of the mistakes investors commonly make are difficult to identify. In fact, most are elementary. The root causes for repeatedly making the same errors are generally psychological. Broadly, there is an element of chance in every equity investment, whether done directly or via mutual funds. And, human beings are generally not too comfortable psychologically in handing the element of chance.

I've often thought that most investors focus on entirely the wrong things in terms of handling money. The focus in most cases lies in learning to identify a good business at decent valuations. This is important but it's definitely not the most important tool in the investors'arsenal.

However skilled an investor might be at balance sheet analysis, he or she will have to live with the fact that he will be wrong close to 50 per cent of the time in investment selections. Tossing a coin could be almost as efficacious when making a buy/sell decision. There are also broader macro-economic risks that cannot be easily assessed. For example, a war or an assassination can easily derail the stock market for an indeterminate period.

The successful investor is the one who can retain psychological balance while dealing with the inevitable losses. This is as true for a Warren Buffett making billion-dollar bets as it is for a small investor putting down Rs 10,000. When something goes wrong with the plan, and a position runs into the red, what do you do?

There is very little literature on this and yet, this is where investors need the most help. There is no simple formula for handling this situation but there are mistakes to be avoided. Some investors panic and sell off their entire portfolio. Others get stubborn and decide they could not possibly be wrong and increase their exposure to the losing stock.

The sane thing is to try to identify what went wrong in an unemotional fashion. This might mean humbly accepting that the initial buy decision could have been wrong or understanding that the laws of chance have moved against you. Crossing this psychological barrier and learning to analyse the underlying reasons for every loss is one giant step towards successful investing,

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