Thursday, March 13, 2008

Same mistakes during market downturns

Stock market has been swinging violently off late. No wonder history repeat and so are our mistakes. It is sad to see people emptying their money from stocks and stock mutual funds avoid loses. What we do not realize is by withdrawing money during market downturns, we are following worst way to invest - "buy high. sell low." People re-enter the market once again when the stocks go up. Making same mistakes again. Buying high. Selling low.

I have always wondered why people get into stock markets if they do not have stomach and patience in the first place. First of all, if you do not have excess money after you have put aside money for emergencies, no point in investing money in the market. It takes decades of patience and perseverance to make money in the market. If you can invest for a long haul, diversified portfolio can yield 8-10%. That's about it.

I think people have some money and instead of keeping it aside for emergencies, they invest all that they have in market and get nervous when the market goes down. Who can blame them? If you have invested your emergency fund in the market and if the market goes down, it can make anyone nervous.

Invest funds excess of your emergency reserve and that you do not need at least for next 5 years. Once you invest in the market, stay put for a long haul. If you buy individual stocks, cut your losses. It is far better to limit losses than hope that you will somehow recover the losses. It is true that overall market comes up but not individual stocks.

By buying and selling frequently, you are making others rich at your expenses. All those trading costs add up and affect returns.

Once again basic principles if you want to dabble in individual stocks.

1) It is difficult to manage more than a dozen stocks at a time.

2) Buy value stocks. Value stocks are good stocks which are trading around 15 P/E ratio.

3) Cut your losses. Rule of thumb is to sell a stock if it falls by 5%. Set an automatic stop order to sell at 5% drop as soon as you buy the stocks.

4) Lock in gains. Set a trailing stop order once the stock appreciates by 10%. By setting trailing stop, you will lock in some profits and minimize loses.

5) Trade less. Even with discount brokers, trading costs add up.

6) Remember to write off losses in tax returns.

7) Put only a small percentage of your assets in individual stocks. As an individual investors, out abilities are limited by how much time and effort we can spend researching the stocks compared to full time traders and their support systems. Rule of thumb - 20% of your total assets. If you have 100,000 to invest, it is wise to keep individual investments to less than 20,000.

8) Park rest of your money in diversified portfolio of stock and bond mutual funds and forget about intermittent market changes.

It is easy to make decent money with basic discipline and commonsense. It is just that simple things are always complex for us.

Very best with your portfolio.


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