The one big risk of directly investing in stocks

by Manshu on September 28, 2012

in Opinion

Nifty is up about 20% so far this year, and that means people are slowly getting back to talking about stocks. I see it on my Twitter, Facebook, personal circle and then of course the blog.

I saw an interesting comment from Mr. Ramamurthy the other day, and I thought I’d do a small post on the topic.

First, the comment.

Ramamurthy September 22, 2012 at 7:17 am [edit]

Many times I hear the argument that investing in Equity direct requires research and analysis. It may be necessary for a trader. But, for the long term investor, I don’t think it is. The theory is if do not have the required expertise, invest through mutual funds and avoid direct investing. I am a long term investor and I don’t do any technical analysis or detailed research before choosing the company to invest.I choose big companies with long history behind it. I choose the sector with which I am familiar with. This does not require much research. So far (last 8-10 years), this tactic has been good to me. I did investment through MF also. I withdrew from them after looking at their pathetic performance and after giving the a long rope (5 Years). Expertise of MF managers?

As I’ve written before, I am a retail investor who invests in stocks directly too, so I obviously don’t buy into the argument that small investors shouldn’t invest in stocks directly.

But I do believe that you run considerable risk when you buy individual stocks. If you buy a few mutual funds then probably the maximum exposure to any single stock is 6 or 7 percent, but if you own individual stocks then you may just own 10 or 15 and within those, you may be concentrated in a few companies. If that’s the case and something happens to one of your companies then your portfolio can take a big hit.

You can reduce this risk to some extent by investing in big companies with long histories but then we all know of big companies that have failed too. And even otherwise, often stocks fall 10 – 20 percent in day like IFCI fell yesterday so that will have a big effect on your portfolio if you owned such a stock.

If you’re at a stage in your life that you already have a huge corpus invested and you take a huge hit like the one I spoke of earlier then that can be devastating to your portfolio.

There are a few ways to get away from this risk (albeit not completely).

You can diversify this risk by owning a number of stocks and limiting your exposure to any single one by less than 5%.

Holding cash so you can invest in times of crisis like last year also helps alleviate this risk because you will be able to buy stocks at a low price. This also helps when there is an eventual rebound in the market because at that time you are inevitably sitting on gains.

Another way to alleviate the risk is to be invested in fundamentally strong companies which have little debt, no promoter pledges and a good track record with disclosure and governance. This also means you stay away from penny stocks and other shady companies.

However, at the end of the day there are risks that come from investing in equities directly, and you can only diversify them so much. If you are going to invest in stocks then know that things can always go wrong, and when they do, it’s your responsibility and no one else’s.

{ 9 comments… read them below or add one }

Manshu September 28, 2012 at 9:49 am

Pasting Mr. Ramamurthy’s comment here from the Suggest a Topic page since it is for this post.

“This has reference to Manshu,s comments /post titled”BIG RISK IN DIRECTLY INVESTING IN EQUITY STOCKS”.I totally agree.But the alternative is to leave the selection of the stocks to invest to Mutual Fund managers and therefore, to invest in a Mutual Fund.They are supposed to be experts and you are not.I was also of the same opinion and used to invest in MF.I gave them a long rope of about 5 Years and invested only in 5 star(Value Research) rated Funds. My experience was to say the least was not satisfactory.I withdrew the money from MF and started direct investment since about 2 years. So far the results are good.Hope they will stay good also.My exposure to direct investment in Equity is about 15% of my total investment.As I have told you I am NOT an expert.”

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thenub September 28, 2012 at 11:36 pm

You need a significant amount of time and effort to invest directly. You need to keep in touch with what’s happening in the market to take decisions on when and what to buy/sell.

For people who don’t have time to keep an eye on the markets and are sort of disconnected from the process, direct investments are harder to manage than MFs. Even a sip in index fund might work out better.

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Manshu September 29, 2012 at 5:10 am

I think that’s the whole point of Mr. Ramamurthy, that you really don’t need as much time and expertise as it’s made out.

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thenub September 29, 2012 at 1:37 pm

“you really don’t need as much time and expertise as it’s made out.”

My point is you _do_ need to put in time and effort in stock picking. This requires many hours/days – find a list of stocks you are willing to invest in, then the stats (market cap, ratios, look at results, etc.). If you have time and inclination to do all that, yes, it’s probably easy (Peter Lynch’s book says so too).

Ask a layman a simple question: Which stocks would he buy out of tcs, infosys, icici, hdfc, sbi, icici, axis, ril, lnt, kotak, coal india, and other nifty shares (for simplicity) for his retirement fund.
I’d spend days, no, weeks and still be scratching my head; Not so simple question now, is it?
I’m pretty sure I’m not in the minority.

Heck, even picking FDs is time consuming and risky! xyz bank, dhfl, sriram, hdfc, m&m, icici, lic… which one?

A lot of people on this site are curious about money management and might probably put that extra effort.

I don’t want to put in so much effort. These things don’t interest me much. I would like to spend as little time on the process as possible. Say, like savings a bank FD, or PPF. Stash some money in there, and not worry about managing it, but get inflation beating results for retirement.
I would like to spend whatever few spare hours I get in the week doing things that interest me, and outsource the burden of all this to someone else.

My point, Manshu, is that you are grossly underestimating the effort required for most people not in the business of money.

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Sorabh Saxena September 30, 2012 at 11:19 am

I agree with thenub,
if we see Rammurthys sir’s time horizon we all know last 5 yrs markets have been sideways we are today at the same sensex level where we were in Oct 2007, hence his non performing MF and we also know that the last two years have been rewarding to direct equity investments, hence his returns in equity in last two years. So thats understood.

Also rammurthy sirs portfolio has only 15% equity , the whiplash if any would not be as severe as would be in your or mine case where we have around 90% equity in our portfolio. i am not a big fan of SIP or any other thing, but i feel most people are like me have a day job and a family to feed, we rarely have the time to learn study and be an expert in Stock Market. There are people who get paid just to do that… so for starters lets trust them and just like in any profession not all the MF managers will be brilliant, we need to atleast put effort in and see who are consistent…

also SIPs dont work in sideways market or rising market as you tend to keep making purchases at high costs bringing your acquisition cost higher and reducing your potential profits…. what to do..? Keep sipping.. but dont give the long rope to a particular fund for 5 yrs or so as high acquistion costs will eventually catchup on this long duration and you would be just average , to verify this check out any top funds 3 yr and 5 yr returns, most likely you will find the 3 yr return more attractive ……

we all can find time once or twice a year to review our funds performance, we should be willing to chuck the fund if its not giving u anything… Also via portfolio rebalacing only can we “sell high and buy low”.. Problem which usually is with most of us that we dont have that extra cash to buy low when markets tank…. to have cash at t
hat point we must be willing to take profits at the top.. what should be the trigger to rebalance the portfolio, in a previous post i wrong “major market moves” which a visitor quoting making funny remarks on that …. what i meant was the trigger should be when my equity to debt ratio gets skewed….. if its 90-10 equity to debt and i am having 95 5 right now… i will take that 5% off the table… simple..

Just a few weeks back my MF SIP portfolio which was 2 yrs old was showing 3.5% profit, two weeks in now its showing 12% profit, thanks to the QE induced rally … i am happy with that… as i am writing this i am shaving off that profit… replacing the laggard funds with some other peers, all this once in two years is justified…. will keep the 12% profit in debt and if opportunity presents will use those funds to “Buy More” when markets crash…
following is a good video espousing the benefits of rebalancing.

http://www.youtube.com/watch?v=HCCO3SOwHv8

regards
Sorabh

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harinee October 1, 2012 at 11:53 am

Thats good analysis Sorabh. I have never understood the term “sideways”.Its up or down what does Sideways mean?
Apart from the time people also need to have aptitude or interest for stock analysis. Everybody is not financially inclined or good at numbers or financial analysis.
I come from a non-commerce/accounts background and it is taken tons of time for me to understand even basics.
But for a person whose job involves such things it is easy to make the time.What I do in my day job has nothing to do with finance. I disagree with Peter Lynch even with inclination and a bit of time its hard for some of us.

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moronbuffett October 1, 2012 at 12:24 pm

Give a monkey some darts. Put a dart board with the list of 500 stocks in the market. Let the monkey throw. Choose the stocks. —- A Fund manager is born

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Manshu October 1, 2012 at 7:58 pm

haha, that’s funny 🙂

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Sunny October 2, 2012 at 7:21 pm

After the recent upsurge the retail investors are suddenly looking to invest and make money in the run up. But like Manshu said, its better to limit exposure to a stock to 5% and pick quality stocks. I am currently chasing some of the beaten down banks which have given me good returns like IDBI, ICICI, SBI etc.

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