Investing directly in stocks can be exciting, but consider the risks


Has the sharp rally in markets after the sharp drop in March 2020 lured investors into a false sense of comfort with direct equity investing?

The risks faced by retail investors who invest directly in stocks are well known. These stem primarily from the limited ability to pick the right stocks and plan the investment, lack of resources to hold a diversified portfolio, and inability to manage behavioral impulses, especially when markets correct.

Even as stock markets reach new highs, it is good for investors who may not be prepared for a market correction to have safeguards in place to mitigate risk.

The intrepid investor

Due to the lockdown caused by covid-19, a large number of people working from home had free time, excess money since spending was limited, comfort with online business transactions and enough stock selections and recommendations at your fingertips. “India is a very underserved equity investment market. So the interest is a positive development,” said Gaurav Rastogi, CEO of Kuvera.in, an online mutual fund platform.

For investors who have made easy money in this race, Rastogi suggests a reality check. “Can you explain what is your investment advantage that will make your stock portfolio outperform? Do you have access to information before the rest of the market? Do you have an analytical advantage that allows you to better process information or a behavioral advantage that helps you build discipline in investing? The first two are unlikely for a retail investor compared to professional fund managers. The latter can be a real source of competitive advantage, but it is the most difficult advantage to cultivate given the deluge of information that causes investors to trade frequently to their detriment,” he said. If investors answer these questions honestly, they will see how gains in the recent past are more luck than skill.

As long as these investors view this trading-dominated foray into the stock market purely as a tactical game and do not embrace it as a long-term investment strategy, the risk can be contained. “Don’t be swayed by beginner’s luck. Set goals and get out whether you make gains or losses. If you lose money, it’s a lesson learned. Let’s leave it at that,” said Santosh Joseph, CEO and Founder of Germinate Wealth Solutions LLP.

The careful explorer

The sharp rise in stock markets after the March 2020 correction has also caught the attention of those who have adopted long-term goal-oriented investing as a strategy. They saw it as an opportunity to test their favorite theories on how to beat benchmarks. Although the recent rally may have justified their ideas such as investing in a few stocks and making gains through frequent trading, these strategies will not hold up well in a typical volatile market.

A study by Kuvera to understand whether it was better for investors to invest directly in the markets compared systematically investing in 275 top stocks over a three-year period to that of a Nifty index fund. The SIP in the direct stocks gave an average return of -0.9% versus 4% in the index fund. Only 90 stocks had returns above 4%. The challenge for investors was to identify one or more of these stocks, which requires skill and time that most retail investors don’t have.

Naveen Julian Rego, Sebi Registered Investment Advisor and Certified Financial Planner, accepts this need to include direct actions as part of his clients’ investment strategy, but he has checks and balances in place. First, it sets a minimum investment limit in equity funds so that there is some equity experience. Second, it establishes a short list of actions to facilitate the selection process. For investors who want to exercise their skills to the fullest, he recommends limiting them to 5-10% of their equity allocation. “There should be a clear separation between their long-term portfolio and tactical investments,” he said.

The dissatisfied researcher

The market correction also attracted investors looking to fill gaps in their professionally managed portfolios. These included gaining exposure to stocks and sectors they were bullish on, investing in small caps that are underrepresented in large cap focused portfolios, and taking advantage of momentum in specific themes.

While their concerns may be real, investors need skills to be able to identify opportunities in the markets and assess the impact on their portfolios. “Investors whose expectations have not been met may not even want to consider data that may show that the alternative they are considering may not have performed better. They will learn best by living experience,” Rastogi said.

Rego added that sticking with a well-thought-out asset allocation and not allowing direct equity investments to change that significantly will help these investors manage risk.

what investors can do

Investors looking for greater control over their investment portfolio can consider exchange-traded funds (ETFs) that offer the benefits of a diversified portfolio and real-time pricing. Rego said ETFs, which use filters such as value, quality and volatility to refine the portfolio, can be used for nuanced direct market investing and that too at low cost.

He added that investors may also consider picking stocks that are part of indices to mitigate risk.

It’s also important for investors to keep behavioral issues at bay. Pursuing investments that have recently skyrocketed significantly, refusing to exit one that is underperforming (in some cases, adding to it), and not selling investments that have gained significantly to rebalance the portfolio are all manifestations of emotional biases that affect the effectiveness of direct equity investment.

Costs and taxes will further reduce short-term gains.

Investing directly in stock markets can be interesting when the markets are in an uptrend. But investors should do so with caution and with due consideration of the impact it will have on their financial well-being when stock markets return to their normal state of volatility.

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