Seven expensive mistakes to avoid while participating in the capital markets

I was introduced to capital markets at a very young age looking at my father (a retired lawyer) fiddling with various physical contract notes and calling up brokers through our landline while Udayan Mukherjee used to come on the TV screen of CNBC India, which used to be on high volume in our home. Seeing a ticker run and random quotes and prices flash on the screen throughout the course of the day was a fascinating experience to grow up with. More often than not, my father’s emotions used to vary directly in proportion to the movement in the Nifty, a trait he has managed to soften in the last 25 years.

With that beginning and having worked with financial statements for almost a decade as a part of my academic and professional career, here is a list of seven expensive mistakes that have taught me a lifelong lesson:

1.   Putting all my eggs in one basket – When I got my first salary after becoming a Chartered Accountant in 2017, I wanted to put all the money in a Fixed Deposit. To this, everyone, right from my father to my closest friends objected. They lured me into looking at the superior returns equity has delivered over the past decade. They told me about concepts of the opportunity cost of losing out on higher returns and tax inefficiency, leading me to change my decision and go all-in on equity. Here is where I learnt my first life lesson – Asset Allocation. You see, asset allocation is key to any personal portfolio. One should start investing once they have a sufficient margin of safety and a comfortable cushion to fall back on. The age-old saying of “do not put all your eggs in one basket” couldn’t have been truer.  It is important to diversify your investible surplus across asset classes – equity, fixed income, metals, cash etc. This shall give you the truest benefit of diversification.

2. The sunk cost fallacy – Let me give you an example to explain this. You’ve bought a non-refundable movie ticket. The review for the movie is horribly bad and everyone you come across tells you not to go for it. A part of you inside you says, since I’ve paid for the movie, I should go watch it. That right there is the sunk cost fallacy.

In the investing world, this fallacy comes into play with a common trait we’ve all done ‘averaging the losers and selling the winners’. Say you buy a stock at Rs 10, it goes down to Rs 8, you buy more. You keep repeating this process till it reaches Rs 1. What becomes so great about the stock when it is at Rs 1 which you could not see when it was at 10?

And how do you fund this purchase?

You have a stock sitting at Rs 15 that you had bought at Rs 12. You sell that stock. Another stock you had bought at Rs 15 is sitting at Rs 22. You sell this too.

As an investor, it is immensely important to get over the sunk cost fallacy.

3. Stop Loss – Whether you’re an investor or whether you are a trader, if you do not have a stop loss pre-defined, you are destined to lose everything. Say you buy a stock at 100. Before entering the purchase, based on your risk tolerance, you need to define the stop loss. What is a stop loss?

A level beyond which you will no longer be in the stock, irrespective of whether you’re investing or whether you’re trading. It could be 5%, 10% – a level till which you’re comfortable seeing your money go away. As a rule of thumb, it is advisable to have a lower range of stop loss for a shorter time frame.

4. Getting over-ambitious and proud – There was a time when I was so convinced with one stock, I wanted to be on their ‘More than 1% shareholding’ list. A goal so ambitious that I ended up pouring all my hard-earned money month on month, year after year only to sell the entire position at a 40% loss after 2 years. Pride that I cannot be wrong and being over-ambitious led to grave financial consequences.

5. Position Sizing – A lot of conventional wisdom does not talk about position sizing. Once you have defined your asset allocation levels, it is also important to go a step further to define your individual position sizes. This holds true for both investment and trading.

Say you have an allocable investment amount of Rs. 100 that you wish to invest in 6 stocks. You need to get your position evened out across these stocks to avoid unnecessary skew bias. For some reason if say one stock goes to 0, you still have 5 out of your initial 6 stocks with you for investing.

Position sizing becomes particularly important if you are entering into F&O trades. Retail investors are easily lured into the F&O segment thinking of making a fast buck, only to realize they’ve lost all their money. More on this later.

6. Risk Management – While most people talk about returns, risks are often ignored. You see, as an asset class, equity carries risk which is higher than say putting your money in a Fixed Deposit.

Howard Marks once said the more you increase the risk, the more the range of return expectation increases, ultimately leading to the possibility of getting negative returns. Risk management becomes very essential especially if you are undertaking F&O trades.

Putting a stop loss and undertaking position sizing goes a long way in managing your risk to avoid any possible external shocks that are not in your control. While accounting for the expected upside, it is also essential to account for the downside.

7. Leverage, Margin and losing track of a system – Most brokers in India provide you with a margin against your existing portfolio of shares to undertake trades. What this means is say if you have a portfolio of Rs. 200, you can undertake trades of say upto Rs. 150 – Rs. 180 depending on the securities you’re holding without paying up. This is all good as long as you’re undertaking winning trades or making money on your investments. All hell breaks loose when this goes the other way. If the trade goes the other way and you do not have proper risk management practices in place (your own ‘system’ consisting of stop loss, position sizing and being disciplined), it may end up in a situation where your entire portfolio has to be forcibly sold to fulfil the margin call.

On the other hand, taking on leverage / debt to take trades is a strict no. While I have never engaged in the latter, the former has blown up my personal portfolio multiple times causing regrets.

This article was originally published for Moneycontrol and can be accessed here.

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