Defer stock-specific decisions for now, be cautious with contrarian bets

Cost averaging, contrarian bets and taking margin funding should be strictly avoided

Recently, Zerodha, an online stock broker, studied the holdings and positions of its clients as part of its risk-management strategy. And the results weren’t awe-inspiring. In the case of Yes Bank, 200,000 of its clients held the stock with 59 per cent of unrealised losses. The total number of investors on its platform who held the stock was 700,000. Worse still, around 200,000 had bought the stock four times on an average, clearly indicating that they were trying to do cost averaging. The stock had hit its 52-week high of Rs 285.90 on April 4. At present, it is trading at Rs 41.15, down about 86 per cent from its peak six months earlier.

 The broker found a similar pattern with Ashok Leyland, where its clients had an unrealised loss of 40 per cent. In Tata Motors they had over 51 per cent loss. “The stock buying pattern showed that retail investors repeatedly make the same mistake in a market like today’s, where barring a few index stocks, most others have seen a significant correction,” says Nithin Kamath, founder and CEO, Zerodha.

Catching a falling knife: It’s common for retail investors to get attracted to popular names witnessing a correction, especially if the company has a track record. They tend to pick up such stocks if there’s a significant single-day correction of over 7-8 per cent, or if they see that the share is close to its 52-week low. The reason: They think the stock will bounce back and they will be able to make a quick buck. Such a buying pattern is also popularly seen when the United States Food and Drug Administration (US FDA) issues warning letters to domestic pharmaceutical companies.

Stock experts say that an investor has to evaluate the correction in the wake of the new development. “An investor has to understand the reason for the correction and its impact on the business before getting into a stock. Just because it has seen a substantial correction is not a good enough reason to buy it,” says Siddhartha Khemka, head-retail research, Motilal Oswal Financial Services. In the case of pharma companies, for example, the investor should try to understand the US FDA’s observations, their seriousness, and their impact on the business.

Khemka points out that typically, retail investors are also attracted to stocks that have corrected after a sharp rally. He points out that many Indian commodity stocks went up early this year as commodity prices were rising globally. When commodities prices stabilised, these stocks started correcting. Many retail investors took a position in them at that point. “Investors need to understand the business and its cycle. If they are caught on the wrong side of the cycle, they will burn their fingers,” says Khemka. For those who don’t do their research, it’s best they stick to proven names that have given steady returns in the past, such as well-run private banks.

Investors should also not fall into the trap of buying stocks as they fall for the sake of averaging out the price. This is the single biggest mistake made by both experienced investors and beginners. A few times, averaging out a stock buying price may work. But the issue with this strategy is that one bad trade is enough to wipe out all previous earnings and more.

Be cautious with contrarian bets: Going against the grain can be rewarding but not without your own research. The definition of contrarian investing is different for different investors. For some, a contrarian bet can be if a stock falls below its 52-week low. For others, it could be attractive valuations after a correction. Picking contrarian stocks, however, is difficult. The stock may remain range-bound for years before its price starts to rise. 

One market expert cited the example of ITC. The stock made its 52-week high on April 15 at Rs 310 and its 52-week low on September 18. It’s difficult to say whether it would turn out to be a contrarian bet or a value trap. ITC can be a contrarian call if its cigarette business stabilises, and the operating profits from fast-moving consumer goods (FMCG) segment rise. Even if you see a contrarian stock, stock experts say that wait for the market to discover it. Until then, keep it on your watch list. This way, an investor would get some gains and won’t fall in a value trap.

Emotions can get the better of you: Many investors start looking at for positive news related to stocks in their portfolio that have seen a significant correction. They tend to look for information that supports their beliefs. This is called confirmation bias and is common in falling markets. It clouds judgment so that investors are unable to make rational decisions. The only way to avoid falling prey to it is to maintain a balanced view on the stock. Don’t ignore the negative information about it. “Keep evaluating the stocks you hold. If there’s a change in the underlying business, you need to thoroughly evaluate whether to hold or sell it,” says S G Raja Sekharan, who teaches wealth management at Bengaluru’s Christ University. He adds: “Mistakes are bound to happen. Cut your losses and move on.”

Avoid margin funding: Leveraging in a market like today’s can not only destroy wealth but also lead to a debt trap. An investor should avoid this at all times, but especially in a volatile market. Experts say that the outlook is uncertain at present. A lot depends on third-quarter earnings. If they are not aligned to investors’ expectations, markets could go into a tailspin.