We have all heard of that one friend who made money off selling stocks.
Stocks, if used wisely can offer huge returns, but making the right stock investment is a process that takes a lot of knowledge and luck.
In one sense, stocks are multibaggers.
A multibagger stock is defined as a stock that gives a return of over 100 percent. Coined by Peter Lynch in his 1988 book, One Up on Wall Street, the origin of this phrase comes from the sport of baseball, where each base is colloquially referred to as a “bag”.
If a runner in baseball reaches multiple bases, it is considered a successful play.
Applying this term to the stock market, a ten bagger stock is a stock that gives a return of 10 times the original amount invested, and a twenty bagger would give a return twenty times more than the original investment.
Investing in the stock market can come with its fair share of hits and misses, and especially in developing markets, past performance is no guarantee of future returns, and multibag returns may be indicative of either sustained growth or an investment bubble.
In this sense, mutual funds are relatively safer investments, not because the risk is reduced, but because of the way in which money is invested.
A mutual fund is generally a bundle of stocks, curated by a professional investor who monitors various industries and stocks, and decides to curate the stock based on market performance.
This ensures that the investor gets the maximum value possible out of his or her money. In other words, investing all your money in a stock is basically putting all your eggs in one basket.
If the stock happens to be a multibagger stock, returns can be excellent and a big payoff is certainly on the cards.
However, it has to be stressed that the average investor does not often have an in-depth knowledge of market conditions and trends, which may lead to miscalculations.
This can lead to a loss of money. Which brings us to the next topic: how can you minimize this risk?
The key differentiating factor between stocks and mutual funds is investor behavior, which is often unpredictable.
stock market investment is a game of educated guesses, it is often an impulsive market that can turn on its heels at the drop of a hat.
The fickle nature of the market is reflected in the demand for stocks: when a stock is doing well, everybody wants to invest in that stock. The reverse is also true: when a stock is not doing well, nobody wants to take a chance on it.
On the surface, this seems sensible enough. However, the trick to making money in the stock market is being able to see things coming.
Sometimes, an extra bit of knowledge about the industry makes the difference between a huge multibagger return or a big loss. In the case of mutual funds, even if one stock makes a loss, it is averaged out by the presence of other stocks.
Because the total investment is spread out over multiple stocks, some of them might make a significant profit, ensuring that the loss isn’t too much. In other words: mutual fund investment thrives on making a slew of small, low-risk investment, the sum of which pays off big.
The role of the mutual fund investor is to make sure that he or she picks the right group of stocks to maximize profit.
This crucial difference is something Rajeev Thakkar, Chief Investment officer, PPFAS Mutual Fund, underscored at the ET Wealth Investment Workshop.
Responding to a query from one of the participants who held that he was better off investing in stocks rather than mutual funds, he explained the idea behind mutual funds was to average out the risk.
“Mutual funds are designed in a manner where they will give an average of total stocks held in the portfolio. If a mutual fund scheme has 25 stocks, the scheme’s return will neither be that of the worst stock, nor that of the best stock,” said Thakkar. This way, returns also get average out,” he said.
Although he stressed on the importance of investing in mutual funds, Rajeev Thakkar also had some words of advice for investors looking to get into the stock market.
Investors are human after all, and it is inevitable that some irrationality will creep into one’s decisions when choosing what stock to invest in or sell. Some of these can be easily avoided according to Thakkar.
These are the things to avoid when invested in a stock:
on the other hand, is the misconception that one has not really made a loss until one has sold the stock. For example, if an investor makes an investment of ₹300 on the stock.
Subsequently, the value of the stock consistently decreases over a long period of time, dropping to ₹200, ₹100 and so forth, investors might feel like they have not really made a loss until they have actually sold the stock, because they are irrationally hoping that the price will come back to its original range.
Often, this never happens and a stock keeps losing money. In such cases, the rational thing to do would be to cut your losses and try to recoup some money.
Suppose an investor buys a stock at ₹100, and the value goes up to ₹500. At some point in the past, the investor may have observed that the value of this stock may have touched ₹800.
Sometimes the investor is tempted to wait on the stock till it comes back again to its peak level. Again, this is a decision made on emotion and the investor should seek to profit from the stock while it has made a significant surge in value.
Another important aspect of investing in stocks is to go in with a plan. When the investor is holding an asset, he/she tends to overvalue it, yet when they are a seller, they tend to undervalue it.
This is why it’s important to stick to a plan and a long term plan at that. Another side effect of this is the recency effect, in which investors are swayed easily by the short term performance of the stock.
Based on whether the stock is doing well or not, investors often tend to get too optimistic or pessimistic, and not care about long term impact.
However, having gone through all these common traps one by one, Thakkar also had some words of reassurance for investors: a way to get out of the trap. “The first step is knowing what shortcuts we take and what biases are we prone to and the second step is to try and avoid those,” he explained.
We all might have encountered the term averaging out losses in the markets.
Get evenitis explains the same. Herein people are not ready to understand their losses. Moreover, investors become revengeful and try to recover the losses incurred from the same investment by investing more.
This strategy does not work if it is purely out of ego without pre-empting about the consequences.
In this scenario, we as investors are not ready to give up on a particular stock.
We understand our mistake only when we sell our investment. The motivation of not selling the stocks comes when we irrationally think that the price will come back to the original price and thereby wait for it.
However, this should not be the case.
This effect is to do with recent events.
Say for example a particular stock is doing well, then we as investors repose trust on the fact that this stock is going to generate similar returns in the near future as well.
Therefore, we form an opinion about the stock based on its recent performance. However, we should take into account the long term impact here and not just the off late events.
Let us understand an important concept of compounding that will help us gain a better insight on how much return we can expect on the type of investments that we make.
The formula is:
A = P (1+R/100) ^N
A= future amount
P= present value or amount invested today
r- rate of return
n= number of years or time period
The above formula was learnt by all of us during our school life. The above formula also aptly highlights one of the key concepts of finance. This is because we know the quantum of investment made; the interest rate that is being offered for the investment as well as the amount that we would be getting at maturity.
However, an important thing to note here is that the formula works fine if the interest rate offered is fixed, which is in the case of FDs etc. But this is not the case when it comes to equity markets.
There are measures to be considered when investing in equities, real estate and corporate bonds. This is because there is no predefined formula in such cases, as is the case with FDs (fixed deposits)
A simple behavioral trait that can be explained is when a stock is clocking constant growth; everybody wants a pie of it. However, when the stock is falling, no one wants it. This purely is psychology.
Let us also reflect on a few common behavioral mistakes that investors commit while investing in stocks.
More often than not, mutual funds do not provide the same type of multibagger returns that stocks can give.
If you are a seasoned investor with extensive knowledge of the market, by all means go ahead and invest in the stocks you believe in.
However, if you have a full-time job and do not have the time to monitor stocks consistently, it’s better to trust a mutual fund with your money.
It may not be a multibagger investment, but it’s definitely a solid one, and those make all the difference over the long term.
Disclaimer: The views expressed in this post are that of the author and not those of Groww