Misplaced Love for cheap Stocks

Investors often have a weakness for stocks which look apparently cheap. This is revealed in the following behavior:

1. They buy a stock that is on its way down because somehow a falling share looks a good bargain.
2. They tend to average down. This means that they buy more of the same stock when its price falls in a bid to lower their average price.
3. They like to buy a stock that is quoting low as they feel comforted when they buy 1000 shares of a company that is quoting at Rs 10 rather than 100 shares of a company that is quoting at Rs 100.

Over Diversification and Under Diversification: we have seen a number of individual portfolios which are either over diversified or under-diversified. Many individuals have portfolios consisting of thirty to sixty, or even more, different stocks. Managing such portfolio is an unwieldy task.

Over-diversification is probably the greatest enemy of portfolio performance. Most of the portfolios we look a have too many names. As a result, the impact of a good idea is negligible.

Perhaps as common as over diversification is under-diversification. Many individuals do not apparently understand the principle of diversification and its benefit in terms of risk reduction. A number of individual portfolios seem to be highly under diversified carrying an avoidable risk exposure.

Buying Shares of familiar Companies:

Investors are often tempted to buy shares of companies with which they are familiar. Medical practitioners, for example, may prefer to buy shares of pharmaceutical companies. Perhaps they believe in the adage a known devil is better than an unknown God and derive psychological comfort from investing in familiar or well known companies. Those who have such tendencies however, must realize that in the stock market there is hardly any correlation between the fame of a company’s products and the return on its equity stock.

Wrong attitude towards losses and profits:

Typically, an investor has an aversion to admit his mistake and cut losses short. If the price falls, contrary to his expectation at the time of purchase, he shows hopes that it will rebound and he can break even (he may buy some more shares at the lower price in a bid to reduce is average price). Surprisingly, such a belief persists even when the prospects look dismal and there may be a greater possibility of a further decline. This perhaps arises out of a disinclination to admit mistakes. The pain of regret accompanying the realization of losses is sought to be postponed. And if the price recovers due to favorable conditions, there is a tendency to dispose of the share when its price more or less equals the original purchase price, even though there may be fair chance of further increase, the psychological relief experienced by an investor from recovering losses seems to motivate such behavior. Put differently, the tendency is to let the losses run and cut profit short rather than to cut the losses short and let the profits run.

Tendency to speculate:

The tendency to speculate is common, particularly when the market is buoyant and ecstatic. Try to resist this. You may find it difficult to follow this advice. Yet, in the long run you are likely to be better off if you refrain your speculative instincts.

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