Recognize mistakes and cut losses

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Recently, I happened to see the portfolio of a retail investor. It was a classic example of how not to invest in stocks. He bought shares of three companies for a total investment of around Rs 2 lakhs in 2010. And, when the prices of all three crashed, he bought more of all the three again for Rs 2 lakhs. Two of the three companies have gone bankrupt and the third is a lame duck. His total investment of around 4 lakhs is now worth Rs 4900. Hard earned money has vanished into thin air.Unfortunately, there are many cases of such disastrous investments.

Many investors come to the market lured by stories of huge wealth creation in the market. It is a fact that stocks outperform all other asset classes by a wide margin and create phenomenal wealth. But, it is important to appreciate the fact that this wealth creation is the consequence of intelligent, systematic, long-term investment. Majority of retail investors don’t have the skills to make successful investment.  The retail investor cited at the beginning belongs to this category. For such people, investing through mutual funds is the ideal investment strategy.

All of us make mistakes in life: “To err is human”. Investors make lots of mistakes. Even legends like Warren Buffet have made wrong investment decisions. But smart people cut their losses and learn from mistakes. Unfortunately, many retail investors do not learn from mistakes. Psychology plays an important role in wrong investment decision-making.

Economics assume ‘consumer rationality.’ But we know that consumers often make irrational decisions. Maximization of utility is not always the factor guiding consumer behaviour.  Similarly, investment decisions are made based on emotions.  Greed, fear and a variety of biases influence investment decisions. A powerful bias is “loss-aversion bias”. Selling a stock at a loss is painful to most investors. So, they cling on to their wrong investment. Worse, they buy more of the chaff even selling the wheat. Better investment strategy is to book losses and invest in fundamentally strong shares.As the saying goes, “remove the weeds and water the plants.”

It is important to understand the fact that around 80 percent of India’s corporate earnings come from the most profitable top 20 companies. Most of this TOP 20 are high quality companies with strong competitive advantages over their rivals. And, they are from high growth sectors like financials, IT, Oil & Gas, Telecom, FMCG and industrials. So, it makes sense to remain invested in them and to buy more on declines. Sell the “cats and dogs” in the portfolio even if it leads to huge losses.

Many retail investors don’t have the expertise to invest in stocks directly. That’s why they make wrong investment decisions and lose their hard earned money. Intelligent investment in stocks can create incredible wealth. It is also important to understand that stupid investment decisions can brutally destroy hard earned money.

Investment through SIPs in mutual funds is a time-tested strategy to earn decent returns. In these times of profound uncertainty, investors should stick to time-tested strategies like SIPs. Keep the faith in the India Growth Story and continue investing.

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