Some Assumptions To Check Before Investing
February 19, 2011 4 Comments
The human brain is fascinating in the way it can use a rough form of inductive logic to help us make sense of our very complex world.But the human brain is not infalliable.Mental heuristics in the form of common sense,educated guesses,rules of thumb,intuitive judgments,etc.can help us find a good enough solution fast, when an exhaustive analysis is impractical.But at the same time such heuristics can lead us to over-generalize and make mistakes.Here is a checklist of some common traps to avoid falling into while investing:
- Correlating GDP growth and market performance. High GDP growth rates don’t always translate into stockmarket outperformance. This may be due to three reasons—(a) unlisted companies may contribute to a large part of GDP growth; (b) while the listed companies’ net profit may grow, dilution of capital through periodic issuances will adversely affect earnings per share (EPS) and return-on-equity (RoE), thereby, impacting stock prices; and (c) the nature of stockmarkets, which serve as leading indicators, resulting in prices surging ahead well ahead of the actual GDP growth and, then, plateauing out for a long period once the growth actually materialises.
- Believing that a strong currency is always beneficial. Strong currencies may boost the egos of nationalists, but may not always help the economy. In fact, weak currencies have contributed to the success of countries such as Japan in the 1970s and 1980s. For India too, exports contribute 22 per cent of GDP and, probably, a higher percentage of our market cap.
- Thinking that large mutual fund schemes are automatically superior to smaller schemes. As long as a scheme or fund house employs strong processes and is able to hold on to sensible fund managers, small size is not a limitation. In fact, it can be an advantage for mandates such as mid-cap funds.
- Considering a great company as an automatically great investment. A ‘great’ company may outpace others during good times and display resilience during difficult times. However as investors, the valuation at which it is available is equally, if not more, important. For instance, if you had bought Hindustan Unilever at its peak of around Rs 290 in April 2006, you would be breaking even only around September 2010. During the same period, the Sensex nearly doubled. The company, meanwhile, continued to grow at a compounded rate of 10 per cent p.a. during this period. Sadly, investors who got in at the wrong time, could not benefit from this growth.
- Taking false comfort. Credit ratings are not sacrosanct, they are merely the starting point. Also, some investors invest in initial public offerings, merely because the issue has been vetted by the Securities Exchange Board of India (Sebi). Sebi clearly states that despite their vetting, investors should exercise their own judgment.
- Over-generalizing about a sector. Often, if the leader in a particular sector performs well, its lustre rubs off on the peers. Hence, if Company X posts great numbers, the stocks of its key competitors, will also rise along with that of Company X. Rarely do investors think that Company X’s performance could be at the expense of it”s peers.