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Emotions in control

Jul 4, 2007

In the good times, investing is like planting a tree (money) and watching it grow. In bad times it is about managing risk and one's emotions. Markets are driven by two emotions - fear and greed. Not managing these two emotions can lead to damaging effects on the portfolios. There is a cycle, which takes place when these emotions start playing. Emotions move from fear to optimism to greed in rising markets and from greed to pessimism and fear in falling markets. The fear comes from investors who sell because they are afraid to lose money. However, the fear of missing out on gains leads to greed.

"I can calculate the motions of heavenly bodies, but not the madness of people," Sir Isaac Newton wrote in 1721. The group instinct is a prime factor in a number of financial disasters, like the tech wreck or the massive 565-point drop in the Sensex on May 17, 2005.

In a perfect world, investors would consider all available information before making a buy or sell decision, without letting the effect of emotions. In such a world, bubbles would never happen.

However, the problem is that we see things not as they are, but as we want them to be or as we fear they will become or irrationally, we assume things will always remain just as they are and that whatever the market is doing it will continue to do it perpetuity. Share prices move up and down according to a bewildering array of factors. Lot of confusion exists when buying or selling stocks. We need to follow certain rules to avoid the greed - fear conflict while investing.

No to tips and rumors: Tips and rumors are seen across TV channels and newspapers. At cocktail receptions, dinner parties, business conferences, in restaurants people swap tips about which companies to buy and which to sell. Predicting the movement of the markets are done daily. It is common sense that if they really knew about it, we would be the last people they would tell. Therefore it is important to focus on the individual stocks that one is planning to invest rather than predict the markets.

Do the homework before investing: One must do the homework before investing in a stock. Lot of people would be talking about the money they made, but on one tells about the money they lost. Often a stock's price momentum attracts investors who jump in without doing much research. Without strong fundamentals to back up the price, such stocks more than often disappoint the investors.

Future growth potential: Every current and potential investor must consider the kind of future growth prospects that the company has. This can be gauged from the sector growth, the demand supply trend and the competition in the sector. Also, the economy perspective must be considered. It is always, that the earnings propel stock prices, so your best bets are stocks with already strong but growing earnings.

Diversify: Investing in a particular stock and reaping high returns sounds an exciting proposition. However, it is very difficult to put it in practice and succeed every time. Moreover, the volatility in that stock increases the worries, as the upside as well as the downside risk in such an investment strategy is very high. Investors, hence, need to keep a diversified portfolio, which will keep the risk exposure under check and yield optimum returns.

Valuations: This parameter is the deciding factor to buy the stocks. The stock price carries all the information in the market about the future prospects of the company. The company may have strong growth prospects, higher margins and lucrative market to tap, but if valuations are not attractive then it would not be too sensible to pay a high price. The question is, how much are you willing to pay for the growth?

In the end, the basic human emotions play a significant part in the behavior of the market and stocks. You can either use the emotions to dictate your investments in a negative way, or you can use to your advantage. It is always better to miss a banquet, rather than be a part of the funeral.

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