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VALUE AND PRICE
Small investors should avoid penny stocks and value traps that can lead to losses in the stock market.
Buy low and sell high is the ultimate winning strategy in the stock market. But some investors take this literally and buy very low-priced stocks. Also known as penny stocks, these scrips are not necessarily good investments. Since the market cap is low, they are easily manipulated by operators who lure unsuspecting investors and dump worthless shares on them. They first create a buzz around a stock, indulge in circular trading to push up the price, and then nudge investors to buy at high prices. As the tables show, a few penny stocks have given phenomenal returns in the past six months. Equally, some others have destroyed wealth during the same period. The other problem is that penny stocks are thinly traded and even if the price zooms in the next few days, you may not be able to off-load all the shares. Any attempt to sell in large quantities only brings the price down.
What you should do:
A penny stock is never a good investment, because you are buying it only in the hope of `finding a bigger fool' who will buy it at a higher price. If a share is priced low, it is because the market does not see value. Study the fundamentals of the company. That will give you enough reasons to avoid pouring money into the junk shares.
BUYING OVERVALUED STOCKS
One can go wrong even with the blue chips. Small investors often get carried away by the market euphoria ignoring the `value' of the stock. A good stock at a very high price is not a good investment. This overvaluation can hap pen even at the broader market levels. We studied the Sensex PE and its returns over the past 20 years and found that when the market was overvalued, the one-year average returns were very poor (see graphic).
What you should do:
Pay attention to valuation when you buy a stock. Even if the company is growing very fast, avoid investing in it if the stock--or the market--is overvalued.
FALLING INTO VALUE TRAPS
Buying a stock just because the price has fallen 50% from its peak is not always a good proposition. You may end up in a value trap. Investors who go hunting for bargains in the initial phase of a bear market also get into the value trap. They compare the current price and PE multiples with the earlier peak and start buying because the stock is available `at a discount'. However, the price may continue to fall and losses could mount.
What you should do:
Most all-time peaks are scaled during extreme euphoria in the market and, therefore, do not represent the real value of that stock. Similarly, it is not fair to judge the current valuation of a stock by comparing it with its all-time high valuations. Instead, compare the current valuation with average valuations for the past 5-10 years. You also need to know why the valuations came down. Avoid buying if the fall is due to a decline in growth rates or if the industry is in trouble. Stocks with corporate governance issues usually quote at cheap valuations, buying them is not great idea. Besides, technical analysis says that a stock which has come down to a 52-week low after a long rally indicates that the tide is turning against the counter. This should be treated as a sell signal and not a buy `at a discount' signal.
BUYING FUTURES & OPTIONS
Be greedy when they are fearful is what stock gurus advise. But some investors are greedier than they can afford to be. They get into the high-risk arena of futures and options (F&O) even though they don't have the financial muscle or the acumen. People who missed the initial phase of the market rally may now want to catch up by taking high-risk bets. The F&O segment allows an individual to buy up to five times the margin kept with the brokers. This means that with a margin of `50,000, one can take a position in shares worth `2.5 lakh. But while your gains can be five times greater, so can your losses.
What you should do:
Whether it is the F&O market or the cash segment, don't bite off more than you can chew. F&Os are meant for hedging and retail investors should get in there only for hedging their existing portfolio.They can get into the speculative part later, but only after learning enough about the F&O market and the risks involved there.
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