Some myths which often mislead investors

KIRIT S SANGHVI
Myths have an enchanting quality. No wonder, many have quietly entered and taken complete control of our lives it without our knowledge. They follow us to the stock markets, too. Here are a few myths people nurse about stock markets.

Myth 1: Day-trading will give more profit:
Those who wish to get rich without investing a single penny believe day-trading is the answer. Sometimes they succeed too. However, studies carried out abroad indicate that such people end up incurring huge transaction costs like brokerage, security transaction tax and other charges recovered by the broker. Timothy Vick, the author of a book on Buffettan theory of stock picking, shows how much more return you have to generate to compensate for the transaction costs, for you should remember that transaction costs bring down the effective return on your investment.

Myth 2: Keep your portfolio diversified:
This is not really a myth, but its overplaying is a myth. People believe it is advisable to hold a portfolio as large as possible. According to them, this will provide safety in case of volatility, for all stocks in the portfolio will not move in the same direction. True, all stocks do not move in the same direction. However, this may prove counterproductive to making investment, which is to earn returns. A highly diversified portfolio may at times off set gains that have legitimately accrued in respect of a stock. The correct rule is that a portfolio should be diversified to optimum level—not the same thing as saying it should accommodate as many shares as it can. Quality of portfolio diversification is not decided by companies whose shares comprise the portfolio; rather, it is decided by the kind of shares that comprise the portfolio. Thus, you should pay attention not to the number of companies whose shares you hold, but to the judiciousness of your portfolio. And remember, it makes no sense to keep two stocks in a portfolio that always move in the opposite direction, for it amounts to holding no shares.

Myth 3: Cheaper shares have more potential to rise:
Many believe that a stock traded at 50 paisa is more likely to rise to Rs 2, giving a return of 300%. It happens but only sometimes. Most such shares immediately fall back to their original levels, and if they don’t, you hardly get a chance to liquidate your holding, for, though there is a high price for the time being, there is hardly any buyer at that level. What should matter is not the price of a share, but the company’s capacity to generate return on its equity.

Myth 4: Shares with a particular PE are good or bad:
There are many who pay attention to PE ratio more than it deserves. Some believe a low PE ratio means that the stock may rise, whereas others believe that a high PE ratio indicates the faith of the market in the share, and therefore, according to them, it is a good investment. What should matter is neither the PE ratio nor EPS, but return on equity (ROE). (The author is a chartered accountant)
(Source: TOI Mumbai, 24th Sept, Page 21)