The share price of company ABC has dropped to Rs 220 from Rs 630. Is it a good buy?
Buying stocks just because its price has fallen is not a good idea. At times, they may fall further if the markets believe there is reason for that to happen. One way of trying to spot that is technical analysis. There are ways to determine whether a stock, which has fallen a certain percentage from its peak, is a good buy or not. One way is to wait for Company X to show that its decline has ended and is showing some signs of support. Thus, you can pick the stock up for Rs 200 to Rs 250 whereas earlier you might have paid Rs 300-350 for it.
The other approach is a fundamental one. You would ascertain if the fall in price is due to any negative developments concerning the company or industry. The stock would be a buy only if its prospects are as solid as they seemed, when it was trading at its peak. Investors can also use a mechanical approach to buy stocks, like purchasing an equivalent amount worth of stock every week or every month. Thereby, you not only average your purchase price, but also ensure that you buy more of the same stock at a lower price. This ensures that your average purchase price is closer to the bottom, predicting which is anyway difficult.
I would like to sell some shares as I am gaining handsomely, but I don’t want to pay taxes on these. What should I do?
Sell the stock and pay your taxes too. If you have made profits then the government would obviously like to have its fair or unfair share of it. On the flip side, you would not have to pay taxes when you do not make any profits. In any case now, as per tax laws as prevalent as of March’07, long term capital gains on shares sold through the stock are exempt. Short term capital gains are taxed at 10%. That’s not very taxing on the pocket, especially if you have made handsome profits.
My recent investment has appreciated a lot and I want to sell it exactly at the top. How can I do that?
If anybody knew how, they haven’t told us yet. Some technical indicators such as the relative strength index can be helpful in locating approximate peaks. A fundamental valuation tool such as the price-to-earnings multiple can also help if you compare the current P/E multiple with the stocks’ historical P/E range. If you look at price charts you will realize that seldom do peak prices last for more than a few days. That is also the time when optimism for the stock is at high. You can start selling in small lots: that way you don’t miss a selling opportunity when a stock appears to be overvalued.
Are there any guidelines for selling when you are in the profit zone?
No. Technical analysis can help tell you whether a stock is in an overbought or an oversold zone. But it is important that you set your own price targets and stick to them, unless there is strong reason to not to do so. If prices are fluctuating wildly, one rule you can follow is to use a stop loss, that is decide a level at which your broker is automatically instructed to execute a sell order. But remember that most investors invariably end up selling either too soon or too late. If you sell too soon, you may miss out on a substantial up move. And then there is the temptation to undo the mistake by buying back at a higher price, hoping that the stock will go higher. If you sell too late, again you have lost out.
Stocks often drop excessively on just a little bit of bad news. What gives?
If one piece of bad news gets out, the fear is that more bad news is lurking around the corner. Similarly, if one stock in a sector gets into trouble (especially if it is an event that could easily happen to any other company in the same business), there is a suspicion that others too will suffer. A bank going bankrupt raises concerns about the health of the banking system in general, and if other banks could follow suit too.
I read favorable news about company XYZ in the paper today. Should I buy the stock?
You will probably end up being the last in the queue. Everyone read that news, and the stock price has probably already reflects that news. In fact, stock prices tend to drop on a major news announcements following the old jungle saying: “Buy on rumors, sell on news.”
Since I invest for the long term can I simply ignore the short term?
It is true that a ‘buy and hold’ strategy is superior to one based on timing the market. But you do not have to wait for all negative developments to emerge before selling. Hence, you need to look for positive or negative signals in the short term, which if persist for some time may have long term implications. However, avoid the temptation to profit from short term price swings. It may happen that you decide to sell stock ABC at a price hoping to cover it later at a lower price. But then if the price rise is happening for some sound fundamental reason, you will end up losing. Similarly, it may also happen that you cover up your position at a lower price only to see the stock price fall further as the share may have been downgraded for a genuine reason. It is important that you do not miss the big picture.
How can one take advantage of general fluctuations in stock prices?
If you think the market is “too high”, you might give a stop loss to preserve profits, liquidate some of your positions to capture profits and reduce exposure or delay any new purchases. If you think the market is “too low”, then you might keep some money aside for fresh purchases.
Do I base my buy and sell decision on the basis of the performance of an index?
An index is a barometer. A market index tells us the direction in which the market is headed. Are two or more averages (like the BSE Sensex and the Nasdaq) moving in unison or are they showing a divergence? It is important to know that most of an upward move or a downward in a stock price is strongly linked to an index. Either a broad market index like the BSE Sensex or a sector-specific index like Mindex (from The Economic Times, it represents knowledge-based industries). How strongly is a stock’s price influenced by an index can be determined by calculating its beta. So one strategy is to locate a rising group in a rising market based on beta.
Otherwise, look for sound companies in the group, which have not risen yet and purchase one or more of them. The assumption is that the “best” companies have already been bid up to full value and that some of the remaining will be bid up. Avoid the poorest companies in the group since they may not move at all. Track indices to gauge the broad market trend or use it as a benchmark to compare the performance of your portfolio. Alternatively, invest in an index fund if you are not confident of beating an index by picking stocks on your own. It is a type of a mutual fund that closely mimics a given index.