Investment Basics: How do Stocks Work

If the state of the stock market is a common topic in the
daily news especially in hard economic times, but for those
without a background in personal finance or business,
financial discussions may sound more like a foreign
language than relevant news stories. Forming an
understanding of what stocks are and why people buy them is
an essential aspect of financial education In the modern
economy.

What are Stocks?

A share of stock is a small fraction of ownership in a
company. As businesses grow, they often need large sums of
money to undertake new projects and to fund expansion. One
way businesses can raise money to fund expansion is by
selling shares of stock to investors. Investors buy stock
in companies because the value of stock can increase over
time depending on demand for the stock. When demand for a
certain company’s stock goes up, the price of the stock
rises aid when demand goes down, stock prices fall. Demand
for stock typically follows the performance of the company:
when companies have strong sales and profit the value of
their stock tends to rise. If an investor buys stock in a
company and the value of the stock increases over time, he
can sell the stock for a profit. Profits gained from
selling stocks and other assets are known as capital
gains.


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Are the markets manipulated?

The simple answer to the title questions is: or course they are. While some forms of market manipulatlon are Illegal, people will try them anyway. It isn’t just the big kahunas who try to drive share prices. Anyone who posts a “sure thing” on a chat board, knowing the underlying stock is worthless, is trying to manipulate the market.

 Many investors never dip a toe in the stock market pool, except perhaps for a company 401k. Their reason is that the stock market is stacked against the little person. Big investors, using sophisticated computer programs and manipulating share prices, make it impossible to win, they say. This there is some truth In the first part of that sentence, but it does conceal another point: finding good stocks is a lot of work. A lot of Investors secretly want to convince themselves that they're not missing anything by not participating in the market because the prospect of learning about it is too intimidating.

Even after that work is done, investing requires a cool head and sometimes a strong stomach. What is faulty is not the idea that markets are manipulated, but the conclusion that investors draw from that information. They fail to perceive that market manipulation can work in their favor as often as it works against them. When it’s all said and done the underlying value of sound companies remains. Individual investors are at an enormous disadvantage in very short term trades. It is undeniable that your ability to move huge numbers of shares is nonexistent, and your computer programs can’t compete with theirs.

But over a longer span of time, individual investors start to pull even and often pull ahead. One of the reasons is that Individual investors are accountable to no one but themselves. Hedge fund managers, mutual fund managers, an institutional investors are under constant pressure to produce results This means selling good companies and buying bad ones, lust to attempt to get that temporary bump that will make their numbers look good this quarter. Here’s how you can avoid letting a manipulated market from taking you down:

1) Make sure you trust your advisers. Whether you hire a full time investment manager or just read the financial blogs once and a while, make sure the person giving the advice has a track record you trust and is acting in your interests

2) Watch for accounting tricks. Earnings numbers can be manipulated rather easily. Watch for footnotes that tell a different story than the main text and red flags in the cash flow statements.

3) Think long term. Manipulations come out in the wash. A share price may be driven by manipulation in the short term, but fundamentals drive value in the long.

4) When manipulation acts in your favor, unload some shares. When a great deal of suspicious buying drives up the price of a stock to levels that seem unsupportable, think about taking the money and running if you’re not sure what's going on, try selling part of your stake and hanging on to the rest.

5) Think twice about following momentum strategies, and cast a skeptical

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Common Mistakes While Investing in the Stock Market

Money is a very strange thing–human beings make rational decisions while dealing with most aspects of life but make serious errors of judgment when it comes to dealing with money – be it saving, investing, borrowing or spending – and probably none are so glaring then when it comes to investment in equities.

Completely rational investors take totally irrational decisions when part of crowd – their own individual rational minds come down many levels to the irrational level of the crowd. Many a times, individual rational intelligent persons commit simple mistakes while making investment decisions in common stocks. And market has its own method of finding and exploiting human weaknesses.

Mehrab Irani, General Manager – Investments with Tata Investment Corporation points out some of the most common mistakes that investors commit while investing in common stocks.

 

Mistake 1: Trying to catch the top and bottom 

This is one of the most common mistake while investing in equities which most of the investors  commit i.e. trying to catch the top and the bottom, little realizing that only fools can catch the top or the bottom.

No Government, Central Bank, company management, fund manager, analyst or anybody knows what will be the exact top or bottom of any stock, then how does a common investor believe that he / she will be able to catch the top or bottom?

Instead of that, determine the value and target price of any stock in which you intend to invest by whatever method you may follow – fundamental, technical or any other method- and then buy it within 5% to 10% range of your that “buy price”.

You may pace out the purchase over a period of time keeping in mind the current performance of that company and / or the overall market conditions.

But, once you determine the “correct price” for a stock to buy, by whatever method you may follow, and once that price approaches, then don’t wait to “buy at the bottom”, because you will probably never be able to do that.

Remember that if you wait too long to buy, until every uncertainty is removed and every doubt is lifted at the bottom of a market cycle, you may keep waiting and waiting. The same rule will apply while selling also.

Mistake 2: It will come back

This is another common mistake which most of the investors commit while investing in equities – whether on the buying or selling side.

If they see a certain price for a certain stock and they miss buying / selling at that price, then they keep waiting in anticipation that the same price will come back, irrespective of market or individual stock considerations.

For example, somebody might have decided on whatever kind of analysis he / she might have done that Unitech is to be sold. Then he / she saw the price of Rs.530 in January 2008 but “missed” selling at that price; and after that the stock started falling because of general market weakness and fundamental deterioration in the company.

But, the investor, who is influenced by this common mistake and waiting for the “price to come back”, might still be waiting with the current price around Rs.26, irrespective of the fact that the price ofRs.530 stands the chance of not ever coming back!

The lesson to be learned is that if the price of the stock has gone up / down for a change in the prospects of that company or sector, then there is no point being in illusion that the “price will come back”.

 

Mistake 3: Already fallen so much – can’t fall further

This is one another serious mistake which many investors commit while investing in equities. A stock might have fallen “considerably” and hence they believe that now it cannot fall further.

Nothing can be further from truth as this is one of the grave mistakes which results in multiplication of investor losses.

Continuing with the Unitech example, the stock fell from Rs.530 in January 2008 to Rs.240 by March 2008, a massive fall of 45% in just two months. Now, any investor who might have believed that it can’t fall further because it has fallen 45% in 2 months and hence held on to it / purchased it was in for a rude shock as it fell to Rs.20 by December 2008, a massive 96% from the top and also a substantial fall of 92% from the March 2008 level of Rs.240.

Unless the stock becomes attractive on a standalone basis on fundamental or technical or whatever analysis you may believe in, there is simply no logic in believing that “because it has already fallen so much and therefore it can’t fall further”.

 

Mistake 4: Already risen so much – can’t rise further

This is the corollary of mistake number 3 – many times investors believe that since the stock has risen so much, hence it cannot rise further. For example, Titan rose from around Rs.5 in July 2004 toRs.42 by March 2006, stupendous jump of more than 8 times in less than 2 years.

Anybody, thinking that the stock has risen so much and therefore cant rise further and sold it was for a rude surprise as the stock rose to Rs.237 by September 2011, not only swelling by 47 times from its July 2004 price of Rs.5, but also multiplying by around 5.5 times from its march 2006 level of Rs.42.

Hence, unless the stock becomes expensive on valuation basis / future growth expectation basis or any other “price determination” parameter which you might be successfully applying, simply because the stock has risen so much does not warrant a sufficient reason to sell.

 

Mistake 5: Protect your profits or cut your losses

Many readers might not agree with me on this point. Unless you are a short term trader or investing on costly leveraged funds, there is no point in simply trying to “protect the profits” or “cut losses”.

Unless the stock becomes costly on valuation basis or its fundamentals deteriorate on a long term basis or because of some other “price determination” parameter which you might be using, just because a stock on which you are making money corrects, it does not necessitate you to panic and sell out of it to “protect your profits”.

Let’s continue with the above example of Titan.

After multiplying by about 8 times from Rs.5 in July 2004 to Rs.42 in March 2006, the stock corrected to Rs.21 by May 2006, almost halved from its peak of March 2006 in just two months. Any investor who might have panicked and sold the stock then would be in for a nasty surprise as the stock then went on to Rs.85 by December 2007 i.e. 4 times jump from the May 2006 low and beyond that as we now know it has touched Rs.237 by September 2011.

The same principle would apply for cutting losses as you might be cutting your losses just before the stock is on the verge of embarking on its dream run.

Keeping with the Titan example above, suppose you purchased the stock at Rs.42 in March 2006 and it halved to Rs.21 in the subsequent two months and you are nursing a massive 50% loss. On the fallacy of “cutting your losses” if you sell the stock at Rs.21 then you have sold it just before it was getting ready for its next dream run which would lead to many times price multiplication over the next few years.

Hence, remember that after doing your analysis if you feel that the price is right for selling than only sell the stock and not on the misleading notion of protecting your profits because in fact by doing that you might be cutting any probability of serious wealth creation in the future. The same would apply to “cut your losses” fallacy also.

 

Mistake 6: Price Averaging

This is another grave mistake which investors do which takes them deeper and deeper down the loss lane. There is a wrong notion then averaging brings down the purchase cost and hence would be able to sell it at some marginal profit or at least closer to cost price.

Let us move back to the example of Unitech, suppose you invested in 1 share at Rs.530 in January 2008, then “averaged” by buying one more share at Rs.300 in February 2008 and further averaged by purchasing another one share at Rs.240 in March 2008 so that now your reduced “average cost” is Rs.357.

But, what purpose has that served? Today the stock is quoting around Rs.26, down by a phenomenal 93% from the reduced “averaged cost”. An investor can sometimes get an opportunity to exit in the averaged stock at close to the “average cost”; but those opportunities are rare and only for a short period of time and therefore very difficult to capitalize at that point of time.

And finally, if you would not otherwise want to buy a particular stock at a particular price then what is the logic for averaging it if you already own your stock?

Remember; never throw good money after bad money.

If you have made a mistake in selecting a wrong stock, humbly accept your mistake, sell it and book your loss and move ahead, - utilize the proceeds from sale to buy better investments with potential of price appreciation in future.

 

Mistake 7: Stocks gone up so I am right or gone down so I am wrong – The Market Trap

Ego and lack of self-confidence are both negative qualities of a human being and an investor. If you buy a stock and it goes up for no real reason but for market abnormalities, then be smart enough to sell it and get out of it instead of pampering your ego that you are an astute investor or a great stock picker.

Don’t forget that the market is a great deflator of all egos. The same can be true when you might have invested in a stock at a decent price after all your analysis and the stock falls for no deterioration in the company’s performance but for some uncontrollable market reasons – during that point of time there is no need to panic and loose self-confidence and start believing that you are wrong.

Remember, the market can be wrong and is in fact wrong most of the times; so try to take advantage of it abnormalities by using your knowledge, experience and judgment instead of getting swayed away by it and losing your self-confidence.

 

Mistake 8: Efficient Market Theory

Don’t blindly believe in the efficient market theory – in fact, remember that market is inefficient for almost 95% of the time. It is like a pendulum moving from over valuation to under valuation and then vice versa. And just like a pendulum’s movement from one side (over valuation) to the other side (under valuation), it passes through the middle (fair valuation) on by chance.

And if the market was indeed always efficient it would simply be impossible for so many investment gurus and fund managers to “claim that they can beat the market”.

Having said that, over the long term the pendulum does move in the direction of what is right – if the country, economy, sector and the individual stock does perform well than over the longer term the pendulum does put its weight behind it, otherwise not.

 

Mistake 9: Blindly follow the Guru

There is a saying that either you completely trust your judgment, or that of another person; and usually, the other person in the market is the investment guru or fund managers etc.

Kindly note, that you may trust any investment guru of your choice and some investor gurus will beat the market at certain points of time but all the investor gurus cannot in totality beat the whole market on a continuous basis because they only make up the market.

Simply put, everybody can’t beat everybody – for there to be a winner, there has to be a looser also. And kindly note, the buyer and seller are always on the opposite side of the trade and they both mysteriously believe that they are right – but one of them is in fact wrong!

So don’t trust any of the so called Investment gurus as face value (including myself although I don’t claim to be any investment guru but just a student of investing).

 

Mistake 10: Penny Stocks

This is another common mistake which most of the investors commit – buying into penny stocks thinking that the price is already “so low”, most probably in single digit, little realizing their own thinking folly.

The amount of loss which can happen in common stock investing is reported in percentage terms and measured in rupee terms, whether it be a penny stock of Re.1 or a high priced stock ofRs.1000. Therefore, if a Re.1 stock falls to 10 paise or a Rs.1000 stock falls to Rs.100, the loss is 90% in both cases. And most importantly, if you invest say Rs.1000 in either of the above mentioned two stocks and both of them suppose become zero, then you lose your full investment of Rs.1000, irrespective of the initial price of the stock.

So, remember the old saying “penny wise, pound foolish”, the stock price is just a quote in the market and on its own does not have any significance whatsoever, it has to be measured in conjunction with the company’s performance, earnings, book value, dividends etc – a high priced stock may actually be cheap on valuation basis, while a low priced penny stock may actually be very costly if the underlying business does not support even that much of a price.

 

Mistake 11: Fail to past the test of patience and character

Market is a place which will test your patience and character. Many times you might have bought a stock for all the right reasons at the right price but the stock refuses to go up for a long period of time.

Just hang on to it because the day you get frustrated and sell it off, there are chances the stock will then start rising.

Hence, patience and character are key virtues which will be repeatedly tested by the market.

 

To conclude, there are many simple and avoidable mistakes which investors commit while investing in common stocks and I have tried to explain some of the most common ones of them.

Kindly note that simple logical things work far better in the market place rather than complex algorithms, theorems, valuations principles, DCF etc. And there is no other place to test your virtues than the market – be it common sense, logical thinking, patience, perseverance, mental balance, emotional intelligence, performing under stress etc. All the qualities which make a successful human being will be tested by the market –it has its own method of finding and exploiting human weaknesses. Investing is not about beating the market or anybody else, its simply beating your own self, your own negative traits and once you are able to master your own self and become a complete human being, then only you would also become a successful investor.

Avoid the common mistakes while investing in common stocks and embark on becoming a successful investor and a complete human being. All the very best.  

 

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