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Self-defeating behaviour of investors

Apr 11, 2011

Everyone comes to the stock markets to earn 'higher' returns. Definitely higher than that from other investment sources like fixed deposits, bonds etc. Then the greed gets the better of them. Investors start thinking about beating the market and earning supernormal profits in a short time.

While worrying about the profits most investors start ignoring the other side of the coin. The consideration of loss. On the onset, let us clarify that here we are referring to the possible losses on stock investment and not the loss a company suffers time-to-time in the course of its business.

There is good reason why investors stop thinking about the loss. Many a time they see prices of some stocks multiplying several times within a short span. During periods of bull run , they perceive that stocks will move in only one direction i.e. up! In the words of all time great value investor Benjamin Graham "Back in the boom years of the late 1990s, when technology stocks seemed to be doubling in value every day, the notion that you could lose almost all your money seemed absurd." But in reality, by the end of 2002, many of the dot-com and telecom stocks had lost 95% of their value or more.

Now just do a small calculation. If you lose 95% of you money, how much return you need to generate to get back the lost money. It is a massive 1900%. Just to simplify the idea in terms of actual prices, if you have bought a share at Rs 100 and the price of the same goes down to Rs 5, the stock will have to go up 1900% before it touches Rs 100 again. Have you ever thought of making this kind of return? It means you will perhaps never be able to get back the lost money. Many investors suffered similar kind of losses in dot-com bust of 2002 or in 2008 market crash.

So it is very clear that we must take care of the downside first before we think of any return. We must minimize the odds of suffering irreversible losses. That's why great value investors like Benjamin Graham and Warren Buffet always emphasized on having a big margin of safety in the stock market investments. We must consider our risk reward ratio and try to keep it as low as possible. This ratio simply is the amount of risk undertaken to capture the returns to the expected returns from an investment.

To summarise, we believe that investments cannot be a one-sided thought process. While the gains are important, we must never forget about the risk we are taking. And that must be included in our analysis whenever we make any investment decision. Only then we can maximize the chances of achieving sustainable gains.


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1 Responses to "Self-defeating behaviour of investors"

Jose Paul Martin

Apr 11, 2011

There is another way, besides looking at the margin of safety. Many times investors/traders don't know when to exit. But with a Trailing Stop Strategy, they can protect themselves from the downside...

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