Simple ways to invest

Steep fall: Value of investments has shrunk.   | Photo Credit: Photo: Paul Noronha


How does one decide when to buy and when to sell in the volatile market?

What the recent stock market fall (and every preceding one) has shown is that it is critical to decide when to buy and when to sell in order to save the heartburn and yet reap above-average gains. How does one realise this seemingly utopian desire?

The steep fall that the Indian stock market has witnessed over the last few months has no doubt spooked even the professional investors. The worst hit are the ones who invested a significant portion of their wealth in the markets at the peak (January 08), be it in individual stocks or mutual funds or ULIPs. The only comfort that stockbrokers seem to offer to these once faithful clients, who have seen the value of their investments shrink by more than 50 per cent, is that this time it is a global phenomenon and no country has managed to escape the meltdown in asset values (I really wonder how a guy in China losing his money is supposed to make me feel better).

So many opportunities

It is ironical that the months preceding the start of the great fall saw the most number of fresh IPOs (Initial Public Offers) and NFOs (New Fund Offers). The daily calendar for the active investor was filled with a new issue opening, closing or listing. Every opportunity seemed so rosy (or at least projected to be) that the retail investor was utterly confused about were to invest his money. Eventually one ended up investing a little bit of money in everything.

Fast-forward six months, and today you realise that it didn’t matter which stock or mutual fund or ULIP you purchased, they have all dwindled to a fraction of the original value. SIPs and MIPs are no better. Some sectors —especially the most hyped ones such as Infrastructure and Financial Services have been the worst hit. So, what are the consequences of losing all this money?

We sell some of our holdings and vouch not to put even a single paisa into the market henceforth.

We try to reach stockbroker to curse him, but he is untraceable.

The Pay-cheque gets seized by the missus. Hidden hand of In-laws suspected. Or may be it was the last NFO (ironically named R.I.C.H fund) that was purchased using the money saved for a vacation.

All this gives me an ominous feeling that we will always be against the cycle, like a hamster in a vicious wheel. In all probability, as soon as the market recovers and we are able to recoup our costs, we will once again invest in the market seduced by the fresh Bull run and stories of how the new neighbour has made a tonne in stock futures and options. What we fail to realise is that we are setting ourselves up for failure, time after time, by “buying high and selling low”. This is against the cardinal rule for making money in the equity markets i.e “buy low and sell high”.

The average retail investor always thinks that there is some magic stock or fund scheme out there that will make him rich and all he has to do is identify it. In this search for ambrosia, what happens is that he gets sold on all the latest investment schemes and stock tips by the financial advisors, agents or brokers, especially when the market is at its peak. To stay away from this booby trap, the question that one needs to ask is NOT ‘what to buy?’ BUT ‘when to buy?’

Simple rule

The secret to profitable investment is to ‘Pay Less’.

A simple rule to decide when to invest in the stock market can be developed based on the ‘Price-to-Earnings Ratio’ or ‘P/E Ratio’ of the Index. But before going into the P/E of the Index, let me first explain how to calculate the P/E of an individual company.

P/E of a company = Share price of the company/ Earnings per share

Where, the Earnings per share = Net Profit made by the company during the previous year/ Total number of shares in the company

The Index is nothing but a weighted average of the share prices of underlying companies. The National Stock Exchange’s ‘Nifty Index’ represents 50 of the largest companies listed on the Stock Exchange, spread across sectors. Similarly, the Bombay Stock Exchange’s ‘BSE Index’ is a collection of 30 of the largest listed companies in India. The Index can be taken as a representative of the entire stock market. This is why when the Index is down, most probably your portfolio of stocks is also down.

The P/E ratio of the Index compares the share price of all the underlying companies to the annual profit (earnings) of these companies. Whenever the share prices change, the P/E ratio also changes.

Let me give you an example: In Jan 2008, the P/E ratio of the Nifty Index was 28. Arithmetically, P/E= 28 or after cross-multiplying P=28*E. i.e the share price of the underlying companies was 28 times the annual profit (earnings) made by the companies (per share). In other words, you had to pay 28 years’ profit upfront to buy their shares (without considering growth in profit). Doesn’t that sound terribly expensive? You bet! Especially if I were to tell you that today, the same companies are available at a P/E of 12.

As you would have guessed by now, the power of the P/E ratio (of the Index) is that it acts as an indicator of how expensive (overpriced) or how cheap (under priced) the market is. A logical extension of this is to set a lower limit for the P/E ratio, below which you can invest in the stock market and an upper limit, above which you can start selling your holdings.

Below is a graph of the P/E ratio of the Nifty Index plotted over the last 10 years. What comes out clearly is that the tops are attained above a P/E ratio of 25 while the bottoms are attained below a P/E ratio of 15. By investing in the stock market when the P/E is below 15 (Bottom Band) and liquidating your investments when the P/E is above 25 (Top Band) you would have not only protected your wealth but also reaped above average return on your investment.

Disclaimer: Hindsight is always 20/20 and future performance may not reflect the past. But hey! This simple technique will at least help you stay away from the trap of “buying high and selling low”

You can check the daily P/E ratio for the Index on > (Trail: Home page > Indices > Statistics). Next fortnight, I’ll discuss a simple investment instrument through which you can make best use of the above technique and reap safe long-term gains from the stock market.

Let me leave you with a closing quote: “Be greedy when others are fearful, be fearful when others are greedy” (Warren Buffet)

This is a fortnightly column on money matters. Reach the author at > or >