Are you capable of earning profits in stock market?

“The first duty of a man is to think for himself.” - José Martí

Positive sentiments during the post-war era attracted a large number of new investors to the capital market. Many investors were able to reach their financial goals while a few others did not earn profits as expected. Several factors would have attributed to the above stated. Today’s article will focus on the mistakes made by new investors who lacked individualism when investing in the market and followed investment decisions of high-net-worth investors without sufficient reasoning. Differently stated, a form of behaviour referred to as herd behaviour in behavioural finance.

Herd behaviour
“Most people say that Shakespeare rocked merely because most people say that Shakespeare rocked.”
- Mokokoma Mokhonoana  
Herd behaviour is the tendency for individuals to imitate the actions (rational or irrational) of a larger group. There are a couple of reasons for this form of behaviour. One reason is the common rationale that it’s unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don’t. This is especially prevalent in situations in which an individual has very little experience.

This theory explains why certain investors didn’t earn profits as expected. These new investors entered the market when the market capitalization and market turnover were increasing rapidly. Moreover, return to investment was relatively short term (at times even a few days). Almost all stocks were lucrative. In such a context, new investors were lost for investments as all investments looked profitable. Eventually they based their investment decisions on market rumours that were in most situations determined by investment decisions of high-net-worth investors.

When the rumour of a high-net-worth investor purchasing a stock enters the market, the rest of the investors would blindly purchase the stock without sufficient reasoning or research.

There might have been situations where it was profitable, yet the risk of reducing the return to investment is higher when you blindly invest in a stock simply because a high-net-worth investor did so. The next section will spell out how the herd mentality could reduce profits.

What went wrong?
“Do not repeat after me if you do not understand the words. Do not merely put on a mask of my ideas, for it will be an illusion and you will thereby deceive yourself.”
 -  Jiddu Krishnamurti

•  Differences in investment goals

The key towards successful investment is gearing one’s investment decisions based on his/her financial goals. Financial goals are shaped by risk appetite, rate of return, holding power, etc. Differences in these variables would bring about different financial goals between high-net-worth investors and the rest of the investors. Table 1 explains the degree of difference in investment goals.
When a high-net-worth investor intends to enter the director board, return to investment in terms of monetary gain is not given prominence. The investor might even consider entering even an overpriced stock. However, investment goals of medium/small scale investors are geared at monetary gains. Thus, it explains why a certain investor, who blindly follows, doesn’t obtain expected returns.

•  Trapped in market irregularities

There were times when small/medium scale investors based their decisions simply on market rumours of certain high-net-worth investors purchasing shares. This increases the demand for the stock and pushes up the price. Even though the high-net-worth investors purchase shares at lower levels, the majority of the investors would purchase these shares at higher prices, far above the intrinsic value of the stock. The situation intensified when the high-net-worth investors silently and strategically exited the stock while medium/small-scale investors continued to purchase at higher prices.
These investors blamed the market and other stakeholders on their losses. Yet, it is important to bear in mind that it is their ignorance that fuelled such irregularities. The regulator can only educate you and warn you but cannot force you to make the correct decision. It is the duty of the investor to think and act wisely.

•  Missed market opportunities

The market boom was followed by a market correction that brought about lucrative investment opportunities. Most of the stocks were trading far below its intrinsic value. The herd mentality once again prevented investors from reaping the benefits. They were guided by market rumours that were over exaggerated and backed by hidden agendas.


Is individuality key to successful investments?
“Attempt to be fearful when others are greedy and to be greedy only when others are fearful.” - Warren Buffet
The above quotation clearly states the mentality of successful investors. The success of Warren Buffet does not lie on a well mastered skill of blindly following the herd. The pillars of success would be patience, knowledge, ability to not only think out of the box but also  redesign it and last but not least discipline. You have to be yourself and be focused on what you are aiming at. You should be able to act in the market  as an individual who is capable of independently  comprehending market performance and acting accordingly based on his/her own judgment.

You can learn from successful and high-net-worth investors but never imitate unless it is in line with your expectations.
Lessons could be drawn from the behaviour of foreign investors. They exited the market at a point local investors were blindly investing and once again entered the market at low price levels when the market was experiencing a correction in prices. As discussed above, the herd mentality resulted in local investors missing the opportunity.

A successful investment strategy is a homegrown strategy based on one’s financial credibility, financial expectations, risk appetite and holding power. It is also important for one to act with an open mind backed by creativity and knowledge in order to identify the hidden opportunities.

How do you design your very own investment strategy?
This section will focus on the areas investors should look sharp on when designing a winning investment strategy.

“Sound strategy starts with having the right goal.” - Michael Porter
It is vital that you have clearly defined goals formulated based on your needs. Invest only if investment opportunities go in line with your goals. Don’t change your goals based on short-term market fluctuations. Similarly, don’t aimlessly hold on to a goal if it is not feasible. However, well designed your goal is it is important to look at the results often.

“An investment in knowledge pays the best interest.”- Benjamin Franklin
New investors blindly followed the investment decisions of others due to the lack of sufficient knowledge. Investing in the market is not an easy ride. Your profits greatly depend on the hours of homework. It is true that your investment advisor would guide you but the final decision is made by you. Thus, it is vital that you’re equipped with relevant subject matter. Familiarize yourself with related financial reports and research. It is equally important for you to update your knowledge.

“Earth provides enough to satisfy every man’s needs, but not every man’s greed.” - Mahatma Gandhi
A strategy should not be driven by greed. It should be designed in a manner by which you exit a stock when you obtain an expected rate of return.
“A man is what he believes in. Believe in yourself and make wise decisions in the market.”

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20 Insights from Peter Lynch

1. Invest In What You Know
This is where it helps to have identified your personal investor’s edge. What is it that you know a lot about? Maybe your edge comes from your profession or a hobby. Maybe it comes just from being a parent. An entire generation of Americans grew up on Gerber’s baby food, and Gerber’s stock was a 100-bagger. If you put your money where your baby’s mouth was, you turned $10,000 into $1 million.

2. Let Your Winners Run
It’s easy to make a mistake and do the opposite, pulling out the flowers and watering the weeds. If you’re lucky enough to have one golden egg in your portfolio, it may not matter if you have a couple of rotten ones in there with it. Let’s say you have a portfolio of six stocks. Two of them are average, two of them are below average, and one is a real loser. But you also have one stellar performer. Your Coca-Cola, your Gillette. A stock that reminds you why you invested in the first place. In other words, you don’t have to be right all the time to do well in stocks. If you find one great growth company and own it long enough to let the profits run, the gains should more than offset mediocre results from other stocks in your portfolio.

3. On Growth Stocks
There are two ways investors can fake themselves out of the big returns that come from great growth companies. The first is waiting to buy the stock when it looks cheap. Throughout its 27-year rise from a split-adjusted 1.6 cents to $23, Walmart never looked cheap compared with the overall market. Its price-to-earnings ratio rarely dropped below 20, but Walmart’s earnings were growing at 25 to 30 percent a year. A key point to remember is that a p/e of 20 is not too much to pay for a company that’s growing at 25 percent. Any business that an manage to keep up a 20 to 25 percent growth rate for 20 years will reward shareholders with a massive return even if the stock market overall is lower after 20 years.

The second mistake is underestimating how long a great growth company can keep up the pace. In the 1970s I got interested in McDonald’s. A chorus of colleagues said golden arches were everywhere and McDonald’s had seen its best days. I checked for myself and found that even in California, where McDonald’s originated, there were fewer McDonald’s outlets than there were branches of the Bank of America. McDonald’s has been a 50-bagger since.

4. Career risk is more highly regarded than market risk
In fact, between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Success is one thing, but it’s more important not to look bad if you fail. There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.”

5. Stocks are most likely to be accepted as prudent at the moment they’re not.
For two decades after the Crash, stocks were regarded as gambling by a majority of the population, and this impression wasn't fully revised until the late 1960s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments or dismissed as gambles in routine and circular fashion, and usually at the wrong times.

6. Keep your winners, cut your losers
Consistent winners raise their bet as their position strengthens, and they exit the game when the odds are against them, while consistent losers hang on to the bitter end of every expensive pot, hoping for miracles and enjoying the thrill of defeat. In stud poker and on Wall Street, miracles happen just often enough to keep the losers losing.

7. Look for situations, where perceptions are worse than reality
The big winners come from the so-called high-risk categories, but the risks have more to do with the investors than with the categories.

8. Recency effect impacts many investors’ decision making
No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next. This “penultimate preparedness” is our way of making up for the fact that we didn’t see the last thing coming along in the first place. The day after the market crashed on October 19, people began to worry that the market was going to crash. It had already crashed and we’d survived it (in spite of our not having predicted it), and now we were petrified there’d be a replay. Those who got out of the market to ensure that they wouldn’t be fooled the next time as they had been the last time were fooled again as the market went up. The great joke is that the next time is never like the last time, and yet we can’t help readying ourselves for it anyway.

9. All stocks are price cyclical
Companies don’t stay in the same category forever. Over my years of watching stocks I’ve seen hundreds of them start out fitting one description and end up fitting another. Fast growers can lead exciting lives, and then they burn out, just as humans can. They can’t maintain double-digit growth forever, and sooner or later they exhaust themselves and settle down into the comfortable single digits of sluggards and stalwarts.

Sooner or later every popular fast-growing industry becomes a slow-growing industry, and numerous analysts and prognosticators are fooled. There’s always a tendency to think that things will never change, but inevitably they do. Alcoa once had the same kind of go-go reputation that Apple Computer has today, because aluminum was a fast-growth industry. In the twenties the railroads were the great growth companies, and when Walter Chrysler left the railroads to run an automobile plant, he had to take a cut in pay. “This isn’t the railroad, Mr. Chrysler,” he was told.

Another sure sign of a slow grower is that it pays a generous and regular dividend. Companies pay generous dividends when they can’t dream up new ways to use the money to expand the business.

10. About Growth stocks
THE FAST GROWERS These are among my favorite investments: small, aggressive new enterprises that grow at 20 to 25 percent a year. If you choose wisely, this is the land of the 10-to 40-baggers, and even the 200-baggers. With a small portfolio, one or two of these can make a career. A fast-growing company doesn’t necessarily have to belong to a fast-growing industry. As a matter of fact, I’d rather it didn’t, as you’ll see in Chapter 8. All it needs is the room to expand within a slow-growing industry. Beer is a slow-growing industry, but Anheuser-Busch has been a fast grower by taking over market share, and enticing drinkers of rival brands to switch to theirs. The hotel business grows at only 2 percent a year, but Marriott was able to grow 20 percent by capturing a larger segment of that market over the last decade. The same thing happened to Taco Bell in the fast-food business, Walmart in the general store business, and The Gap in the retail clothing business. These upstart enterprises learned to succeed in one place, and then to duplicate the winning formula over and over, mall by mall, city by city. The expansion into new markets results in the phenomenal acceleration in earnings that drives the stock price to giddy heights.

11. THE CYCLICALS
A cyclical is a company whose sales and profits rise and fall in regular if not completely predictable fashion. In a growth industry, business just keeps expanding, but in a cyclical industry it expands and contracts, then expands and contracts again. The autos and the airlines, the tire companies, steel companies, and chemical companies are all cyclicals. Even defense companies behave like cyclicals, since their profits’ rise and fall depends on the policies of various administrations.

Coming out of a recession and into a vigorous economy, the cyclicals flourish, and their stock prices tend to rise much faster than the prices of the stalwarts. This is understandable, since people buy new cars and take more airplane trips in a vigorous economy, and there’s greater demand for steel, chemicals, etc. But going the other direction, the cyclicals suffer, and so do the pocketbooks of the shareholders. You can lose more than fifty percent of your investment very quickly if you buy cyclicals in the wrong part of the cycle, and it may be years before you’ll see another upswing.

12. Boring is good
A company that does boring things is almost as good as a company that has a boring name, and both together is terrific. Both together is guaranteed to keep the oxymorons away until finally the good news compels them to buy in, thus sending the stock price even higher. If a company with terrific earnings and a strong balance sheet also does dull things, it gives you a lot of time to purchase the stock at a discount. Then when it becomes trendy and overpriced, you can sell your shares to the trend-followers.

13. Who are the winners in a cyclical recovery
Depressed enterprises on the edge of disaster can become very big winners on the rebound. It happens again and again in the auto, chemical, paper, airline, steel, electronics, and nonferrous metals industries. The same potential exists in such currently depressed industries as nursing homes, natural gas producers, and many retailers. What you want, then, is a relatively high profit-margin in a long-term stock that you plan to hold through good times and bad, and a relatively low profit-margin in a successful turnaround.

14. Embrace market corrections
It is not entirely clear what causes deep market corrections (a clear prove that markets are irrational), but without them many of the best performing long-term investors would have never achieved their spectacular returns.

15. Hunting for bargains
There are two particular periods when great bargains are likely to be found. The first is during the peculiar annual ritual of end-of-the-year tax selling. It’s no accident that the most severe drops have occurred between October and December. It’s the holiday period, after all, and brokers need spending money like the rest of us, so there’s extra incentive for them to call and ask what you might want to sell to get the tax loss. For some reason investors are delighted to get the tax loss, as if it’s a wonderful opportunity or a gift of some kind— I can’t think of another situation in which failure makes people so happy. Institutional investors also like to jettison the losers at the end of the year so their portfolios are cleaned up for the upcoming evaluations. All this compound selling drives stock prices down, and especially in the lower-priced issues, because once the $ 6-per-share threshold is reached, stocks do not count as collateral for people who buy on credit in margin accounts. Margin players sell their cheap stocks, and so do the institutions, who cannot own them without violating one stricture or another. This selling begets more selling and drives perfectly good issues to crazy levels. If you have a list of companies that you’d like to own if only the stock price were reduced, the end of the year is a likely time to find the deals you’ve been waiting for. The second is during the collapses, drops, burps, hiccups, and freefalls that occur in the stock market every few years. If you can summon the courage and presence of mind to buy during these scary episodes when your stomach says “sell,” you’ll find opportunities that you wouldn’t have thought you’d ever see again. Professionals are often too busy or too constrained to act quickly in market breaks, but look at the solid companies with excellent earnings growth that you could have picked up in the latest ones.

16. About sellingIf you know why you bought a stock in the first place, you’ll automatically have a better idea of when to say good-bye to it.

17. WHEN TO SELL A CYCLICAL
The best time to sell is toward the end of the cycle, but who knows when that is? Who even knows what cycles they’re talking about? Sometimes the knowledgeable vanguard begins to sell cyclicals a year before there’s a single sign of a company’s decline. The stock price starts to fall for apparently no earthly reason. To play this game successfully you have to understand the strange rules. That’s what makes cyclicals so tricky. In the defense business, which behaves like a cyclical, the price of General Dynamics once fell 50 percent on higher earnings. Farsighted cycle-watchers were selling in advance to avoid the rush.

One obvious sell signal is that inventories are building up and the company can’t get rid of them, which means lower prices and lower profits down the road. I always pay attention to rising inventories. When the parking lot is full of ingots, it’s certainly time to sell the cyclical. In fact, you may be a little late.

18. WHEN TO SELL A FAST GROWER
Here, the trick is not to lose the potential ten-bagger. On the other hand, if the company falls apart and the earnings shrink, then so will the p/ e multiple that investors have bid up on the stock. This is a very expensive double whammy for the loyal shareholders. The main thing to watch for is the end of the second phase of rapid growth, as explained earlier. If The Gap has stopped building new stores, and the old stores are beginning to look shabby, and your children complain that The Gap doesn’t carry acid-washed denim apparel, which is the current rage, then it’s probably time to think about selling. If forty Wall Street analysts are giving the stock their highest recommendation, 60 percent of the shares are held by institutions, and three national magazines have fawned over the CEO, then it’s definitely time to think about selling.

There’s simply no rule that tells you how low a stock can go in principle. I learned this lesson for myself in 1971, when I was an eager but somewhat inexperienced analyst at Fidelity. Kaiser Industries had already dropped from $ 25 to $ 13. On my recommendation Fidelity bought five million shares— one of the biggest blocks ever traded in the history of the American Stock Exchange— when the stock hit $ 11. I confidently asserted that there was no way the stock could go below $ 10. When it reached $ 8, I called my mother and told her to go out and buy it, since it was absolutely inconceivable that Kaiser would drop below $ 7.50. Fortunately my mother didn’t listen to me. I watched with horror as Kaiser faded from $ 7 to $ 6 to $ 4 in 1973— where it finally proved that it couldn’t go much lower.

19. The biggest winners are usually a pleasant surprise
The point is, there’s no arbitrary limit to how high a stock can go, and if the story is still good, the earnings continue to improve, and the fundamentals haven’t changed, “can’t go much higher” is a terrible reason to snub a stock. Shame on all those experts who advise clients to sell automatically after they double their money. You’ll never get a ten-bagger doing that.

Frankly, I’ve never been able to predict which stocks will go up tenfold, or which will go up fivefold. I try to stick with them as long as the story’s intact, hoping to be pleasantly surprised. The success of a company isn't the surprise, but what the shares bring often is.

20. Picking bottoms – If they don’t scare you out, they will wear you out
Bottom fishing is a popular investor pastime, but it’s usually the fisherman who gets hooked. Trying to catch the bottom on a falling stock is like trying to catch a falling knife. It’s normally a good idea to wait until the knife hits the ground and sticks, then vibrates for a while and settles down before you try to grab it. Grabbing a rapidly falling stock results in painful surprises, because inevitably you grab it in the wrong place. If you get interested in buying a turnaround, it ought to be for a more sensible reason than the stock’s gone down so far it looks like up to you. Maybe you realize that business is picking up, and you check the balance sheet and you see that the company has $ 11 per share in cash and the stock is selling for $ 14. But even so, you aren't going to be able to pick the bottom on the price. What usually happens is that a stock sort of vibrates itself out before it starts up again. Generally this process takes two or three years, but sometimes even longer.

How many times have you heard people say this? Maybe you've said it yourself. You come across some stock that sells for $ 3 a share, and already you’re thinking, “It’s a lot safer than buying a $ 50 stock.” I put in twenty years in the business before it finally dawned on me that whether a stock costs $ 50 a share or $ 1 a share, if it goes to zero you still lose everything. If it goes to 50 cents a share, the results are slightly different. The investor who bought in at $ 50 a share loses 99 percent of his investment, and the investor who bought in at $ 3 loses 83 percent, but what’s the consolation in that?

The point is that a lousy cheap stock is just as risky as a lousy expensive stock if it goes down. If you’d invested $ 1,000 in a $ 43 stock or a $ 3 stock and each fell to zero, you’d have lost exactly the same amount. No matter where you buy in, the ultimate downside of picking the wrong stock is always the identical 100 percent.

Sometimes it’s always darkest before the dawn, but then again, other times it’s always darkest before pitch black.

Source:
Lynch, Peter; Rothchild, John (2012-02-28). One Up On Wall Street. Simon & Schuster, Inc.. Kindle Edition.

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11 Rules for Anyone Who Uses Charts

By Michael Kahn

As I often say about my wine savvy, I know just enough to be dangerous. For many traders, the same holds true with regard to charting and technical analysis.

They know enough to use an RSI (relative strength index) to gauge momentum but really don’t know why they use a parameter of 14. And they use the same process day in and day out because they heard it once in a webinar or read it once in a book.

Trading teachers will tell us to find something that works and stick with it. I contend that unless you understand the “why” and not just the “what” you are setting yourself up for trouble down the road. After all, markets evolve and what worked yesterday may not work today.

This missive is not about deconstructing technical indicators. Rather, it is to get the reader to think about the spirit of the analysis and letting the charts speak to them. Any other method implies that traders are making the market conform to their own biases.

The market hates that and it will make you pay dearly for trying.

Let’s start with RSI and the 14-parameter. Why do so many traders use it? The answer is that is the default setting on the first applications of charting software that came out a few decades ago. There was reason behind it as Welles Wilder, the creator of RSI, was using half cycles in his favored markets as the basis. But once software coders and inexperienced product marketing managers got something in their heads it seemed to be set for life. Even today, many software programs do not let the user change the default parameter to something different.

Of course, indicator parameters should be in sync with the market and time frame in which they are being used. But it goes beyond that. Because markets evolve, indicators can behave differently than they did when they were newly created. Today, “everyone” sees what they think are overbought and oversold levels at the same time and act accordingly. How many times in recent memory have signals simply failed just because everyone – the herd – is taking the same action?

Rather than over-think an indicator or even a chart pattern, here are some rules that will make your life easier and more profitable. They are all rooted in keeping it simple and more importantly letting the market do all the thinking. All you have to do is turn off the news and absorb the message.

Rule 1 - If you cannot see trends and patterns almost instantly when you look at a chart then they are not there. The longer you stare, the more your brain will try to apply order where there is none.

If you have to justify exceptions, stray data points and conflicting evidence then it is safe to say the market is not showing you what you think it is.

Rule 2 – If you cannot figure out if something is bullish or bearish after three indicators then move on. The more studies you apply to any chart the more likely one of them will say “something.” That something is probably not correct.

When I look at a chart and cannot form an opinion after applying three or four different types of indicators – volume, momentum, trend, even Fibonacci – I must conclude that the market has not decided what it wants to do at that time. Who am I to tell it what it thinks?

Rule 3 – You can torture a chart to say anything you want. Don’t do it.

This is very similar to Rule 2 but it there is an important point to drive home. You can cherry pick indicators to justify whatever biases you bring to the table and that attempts to impose your will on the market. You cannot tell the market what to do – ever.

Rule 4 – Be sure you check out one time frame larger than the one in which you are operating (a weekly chart for a swing trader, a monthly chart for a position trader).

It is very easy to get caught up in your own world and miss the bigger picture getting ready to smack you.

It can mean the difference between buying the dip in a rising trend and selling a breakdown in a falling trend.

Rule 5 – Look at both bars (or candles) and close-only line charts to see if they agree. And look at both linear and semi-logarithmic scaled charts when price movements are large.

Short-term traders can ignore the latter since prices are not usually moving 30% in a day. But position traders must compare movements at different price levels.

As for bars and lines, sometimes important highs and lows are set by intraday or intra-week movements. And sometimes intraday or intra-week highs and lows are anomalies that can safely be ignored. Why not look at both?

Rule 6 – Patterns must be in proportion to the trends they are attempting to correct or reverse. I like the trend to be at least three times as long as the pattern.

A three-day correction is not sufficient to get a six-month trend back on track. And a three month pullback after a six month rally is probably a new trend, not a correction.

Rule 7 – Patterns should have symmetry. A triangle should look like a triangle and not a mile high and an inch wide (or vice versa). A head-and-shoulders should look like a central peak with two smaller but equal peaks around it.

Rule 8 – Price rules but it is better when volume, momentum and structure (patterns) agree. Sentiment is a luxury because it is often difficult to quantify.

No matter how strong the case built on indicators and the environment surrounding the market may be, there is no change in condition until price action reflects it. How many times has an overbought market become even more overbought?

Rule 9 – Always confirm one type of analysis with another type. For example, confirm RSI not with MACD but with on-balance volume or relative performance.

There are hundreds of indicators but only a handful of truly unique types. Be sure you do not try to prove your case with a variation on the same set of input data. Most momentum indicators are quite similar so be sure to look at at least the three types listed in Rule 8.

Rule 10 – Don’t get hung up if all your indicators do not agree. They never will all agree and you will end up missing every opportunity. Therefore, pretend you are a trial lawyer gathering a preponderance of evidence, not guilt beyond a shadow of a doubt.

Rule 11 – If a stop is hit you must honor it. All big losses start out as small ones. No exceptions. Feel free to re-analyze a trade that got stopped out to see if you would enter anew but never justify holding on to a loser.

Again, nothing here is rocket science but these rules force you to let the market talk. After all, that is our job as traders, reading the signs and acting accordingly.
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