The Stock Market Bubble formation

Hello friends, I am Laxman Sonale, In Today’s article, we see the stock market bubble from chapter 10 of the book Stock to riches. In this chapter, the author explains the different types of thinking of participants in the markets. and how the government thinks, and how the system thinks, as well as how operator the benefits of any situation.

What are we learn from this Blog?

if you read this blog carefully then you realize how the system works, and how people play the game of the stock market bubble formation, and make the money. If you are a retail investor, then you definitely avoid this game, how to avoid detail, in this blog,

so let’s start

Previous chapter on Mutual Funds:- honest Review:–

Chapter 10:- The Stock Market Bubble formation

The Stock Market Bubble

In this chapter, the author Parag Parikh talks about the financial bubble that happened in history. Their cause ad psychology of every participant. so let’s understand one by one the reason for their bubble formation and bubble bursts.

In starting the author says, ” The Stock Market are fascinating because they are so unpredictable furious activity is followed by long periods of lull. Many a fortune is made and lost. the Greed and Fear of participants make the stock market volatile. (The Stock Market Bubble)

The one who can understand this and in turn exploit it is easily the master. Stock markets are known for their intermittent bubble. to understand who and what causes them, we need to ascertain how the system works and what drives the participants. Systems Vagaries of the stock markets.”

then the author talks about how the system thinks about it.

System Thinking:-The Stock Market Bubble

In this, the author says, ” A system is that which maintains its existence and functions as a whole through the interaction of its various parts. The human body is a perfect example of a system. It consists of different parts and organs each acting separately yet all working together and each impacting the others.

Similarly, all around us, there are systems and systems within systems. System thinking is looking at the whole picture, the different parts, and the interconnection between the parts.

It thinking in circles, in loops rather than in straight lines. the parts of a system are all connected directly or indirectly. The action of one part affects the other and that other responds to the new influence.

The influence then comes back to the first part in modified ways, making a loop, not a straight line. This is known as the FeedBack loop.” (The Stock Market Bubble)

then the author gives the example of our hunger to understand the feedback loop

Hunger is a good example of this. When you feel hungry, you want to eat. so you eat as much as you need to satisfy your hunger. Once your hunger is satisfied you stop eating.

your hunger influenced your craving for food and in turn the amount of food. you ate influenced your hunger. it looks like one action but actually, it is a loop. it would be only one action if you knew exactly how much food to eat to feed your hunger and you ate that quantity of food.

When two parts are connected the influence can go both ways, like a telephone line; if you can dial a friend he can also dial you.

Feedback is the output of a system reentering as its input, or the return of information to influence the next step.

Feedback is fundamental to systems. there are two types of feedback loops.

Reinforcing Feedback:-

When changes in the whole system return to amplify the original change and this amplified change goes through the system producing more change in the same direction.

An example would be a snowball rolling down the hill. it collects snow as it rolls and becomes larger and larger until it eventually becomes a boulder.

Balancing FeedBack:-

When changes in the whole system return to oppose the original change and so dampen the effect. A balancing feedback loop is where the change in one of the systems results in a change in the rest of the system. that restrict, limit or oppose the initial change and keep the system stable, or else the reinforcing feedback would break the system. (The Stock Market Bubble)

Feedback is a circle. It takes time to travel round in a circle and so the effect can appear sometime after the cause. when there is a time delay between cause and effect and we assume there is no effect at all, we may be surprised when the effort suddenly happens.

What we do now will affect our lives in the future when the consequences come around again. We do not see the connection and we blame prevailing conditions but actually, the roots lie in our own past actions. We mold the future by our present actions.

Very often the most critical point of leverage in any system is the belief of the people because it is these beliefs that sustain the system.

The stock market is one such system and it is its beliefs and the behavior of its. Various participants from time to time shape their progress.”

then author explains each participants psychology, including governments, regulators, stock exchange, brokers, banks, companies

The Psychology of Stock Market Participants:-

At this point, you know each participant’s aim in the stock market, and how they think

in this author says, ” understanding the psychology of the participants is the key to knowing how they will behave when they are gripped by fear and greed. he who understands this psychology is able to manipulate the markets by using the different participants at different times.

Now let’s see what each one wants from the markets.

Governments:-

At this point when the world has become a global village and each country wants to attract foreign capital, governments need booming markets. (The Stock Market Bubble)

Stock markets are the barometer of an economy. they send positive signals to foreign investors when they are in a bull phase.

Booming stock markets create confidence and spur the governments to go ahead with their economic policies. No government likes depressed stock markets.

Regulator:-

Regulators are appointed by the government, the regulator also likes booming stock markets.

A rising market is evidence of good government it also results in additional revenue in the form of higher transaction of services charges due to the increase in turnover.

Stock Exchange:-

They facilitate stock transactions. during boom periods, incomes skyrocket, by way of transaction charges from brokers, listing fees, etc.

Brokers:-

in a bull market, the clientele increase and so do business opportunities. this results in higher incomes for the brokers.

Banks:-

Their business increases with soaring stock markets as opportunities open up in lending against stocks, margin trading, depository, and custodial business. etc.

The feel-good factor drives investors to banks for various financial services.

Companies:-

Rising markets lead to higher stock prices, the net worth of owners increases, and companies can map up more capital for expansions. Financially healthy companies are able to attract and retain good talent and keep their shareholders happy. (The Stock Market Bubble)

Mutual funds:-

Higher stock prices mean increased net asset value rising markets attract more investors which means more money under management fees. they are also able to come out with different kinds of funds to satisfy every requirement.

Media:-

The media plays a pivotal role in spreading information. an increase In investors means increased viewers/readers, which translates into increased advertisements revenue.

Investors:-

The lure of quick money draws investors into a bull market. Day traders become very active as they are rewarded with easy gains.

Operators:-

He is the smartest and shrewdest of all. he is aware that the bull run psychology creates the bull run. He knows the system, he understands the psychology of the participants and he has the ability to exploit that for his own benefit.

He is the king-maker who uses his knowledge to win over investors, brokers, and company management.

after this

the author explains how we make a bubble in the market.

Making the Bubble:-

in starting this point, the author gives the quote

: ” Whoever can supply them with illusion is easily their market.”   – Guston Le Bun

so the author gives three points of making bubble.

1) Stock Price:-

At this point, the author says ” The fulcrum of the stock market is the stock price. the management of companies is the biggest beneficiary of a price increase and it is in its interest to keep stock prices high.

Anyone who promises to boost line prices easily becomes its master.

The operator understands the weakness very well, he tells the management that its company stock is undervalued and convinces it that he can take it higher. in most cases, he is a broker or an investment banker, which gives him the credibility of knowing the stock markets.” (The Stock Market Bubble)

then comes the role of the second point

2) The Deal:-

The management gives the operator some stocks at the current low price and a predetermined amount to rig the stock. the operator uses the money for his stock market operations while his profits come from a portion of the stock he is given at the beginning, which he sells when the price goes up.

A fixed amount of performance fees is also given to execute the deal. Over and above that the operator makes money by way of trading on his own account during the rigging process.

the third point is one circular trading

3) Circular trading:-

This author explains step-by-step circular trading.

Step-1:- The operator has his own band of brokers who specialize in such operations. the circular trading starts, Broker-1 sells shares to Broker-2 who in turn seel broker-3 who then sells to broker-4, and so on.

As the shares change hands the price increase. thus reported volume. when this data reaches investors they think that since the stock is moving something must be happening. (The Stock Market Bubble)

Circular trading picks up momentum and the stock price and volume increase, the referring loop is created. Even if there is pressure to sell the operator absorbs, it with the money given to him by the management.

If the conditions are bullish the operator and his band of brokers also, absorb the selling by taking their own positions.

This creates artificial scarcity and the reinforcing loop becomes stronger. see figure to understand the circular trading process.

circular trading

Creating the Reinforcing Loop:-

At this stage, the manipulators can not exit. they are making the bubble, so they need to support the price, or else the reinforcing loop will break.

the Stock needs to get its momentum before it can stand on its own. So a fund manager of a mutual fund or an institutional investor is roped in to join the inner investment adds credibility to the stock.

Investors are lured by the entrance of these investors. This helps the rigging the gives credibility to the stock.

Step-2:-

Now the stock has got its feet. Regular Volume data and the rise in price attract investors. Saliency heuristic is at work. the rise in stock is seen as a positive turn in the fortunes of the company.

Slowly the stock becomes newsworthy. Stories about the company, its growth potential, restrictions, and so on appear in the stock market, journals availability heuristics at play.

All available information on the company is positive. the recall value for the stock gains prominence and more investors start buying. (The Stock Market Bubble)

The seed of Greed is sowed. With each price rise, demand for the stock increases, and other players such as retail investors join the game. fundamentals and valuations take a back seat.

bubble starts

The initial operator and his band of brokers at this stage do not do much except plant stories in the media, generate excitement about the stock by way of research reports, and convince another intermediate who in turn recommend the stock to their clients.

Essentially, their job is done. the stock is on autopilot. the bubble starts ballooning. at this stage, the manipulators are able to exit.

Stage-3:-

the net is spread, more stock market participants enter the fray. Banks and private financiers look for lending opportunities. the stock enters the list of stocks against which banks will give an overdraft facility.

this further enhances the credibility of the stock the stock builds huge volumes as genuine buying and selling take place.

Enter the media. Stock price movements are flashed on tv screens ad analysts recommend it at investment debates.

the stocks soar further on inflexibility as more and more investors enter the market, afraid that they will miss the bus. this herd mentality pushes the stock still further. Now with greed in the driving seat representative heuristic comes effect makes investors feel that the market is undervaluing their stock and they become more confident of their holding.

they become salesmen for the stock and recommend it to their own friends, and relatives. Each person becomes an expert in his own sphere of influence. the initial operator then exits and move to other stocks in the same industry where representative heuristic is at play. (The Stock Market Bubble)

the bubble is for real and the reinforcing loop is strong. all the participants in the market are happy, as each one is a winner. Between the cause and effect, there is an interval, the duration of which no one can predict. the balancing loop has to come up to play to correct the system is to be stable. nobody can predict when that will happen but happen it will.

The severity of the balancing loop is directly proportionate to the severity of the reinforcing loop.

the buble is for real

then lastly the author explains how the bubble burst,

you can read this in this book, buying this book, from the following link

so this is all about the stock market bubble from book stock to riches.

Stocks to Riches Chapter 4:- Introduction to Behavioural Finance

In today’s blog, we see the introduction to behavioral finance from chapter 4 of the book stocks to riches by Parag Parikh. This is a wonderful chapter you should understand how our feeling is work in the stock market and how can we have to get precautions.

so let’s start

Previous chapter

Introduction to Behavioural Finance:-Stocks to Riches Chapter 4

Stocks to Riches Chapter 4

In this chapter 4, the author explains behavioral finance with wonderful examples

let’s start with examples of peoples behavior

  • “With such positive news from the company why is the stock going down”
  • “I am a qualified chartered accountant. I went through the finances of the company and I feel that at the current price, the stocks are too expensive. I would not buy it nor recommend the same to anybody. But I am surprised that in the last two weeks the stocks are up 15 percent.”
  • “My friend works with this company. they told me that it was doing exceedingly well and that they have an export order worth crore in hand so I bought the stock. It’s six months and I have been waiting but the stock is going down.”
  • ” the company has announced a 1:1 bonus, it’s good news so I bought the stock but the stock went down instead of going up like I thought it would.”
  • ” I read the mornings newspaper and was impressed by the finance minister’s speech and his intention to give sops to the economy. the markets greeted the news positively and went up so I bought stocks the next day the markets were down for no reason and I lost on my investment.”
  • ” I heard the expert’s comments on T.V. on the current budget presented by the finance minister. they were not very happy with it. I sold my stocks only to find that within a week the markets were up 10 percent. I don’t know why I sold my stocks which I had been holding for the last four years.”
  • ” I can not understand the markets. I would rather stay away.”

after his behavioral statement, then the author tells, how this statement happens

the author says, ” Aren’t all these statements familiar you have heard them on perhaps made then yourself. In an ever-changing and uncertain world, we are trying to find some predictions where none exists. The easiest thing to do is to avoid such irrational markets. But then you would be missing out on one of the most favorable modes of investment. (Stocks to Riches Chapter 4)

My sincere advice would be to catch the bull by the horns. confront the problem rather than run away from it. Try to understand why it is happening to you.”

then the author gives their own experience, in dot com bubble time.

the author says, ” during the IT bubble. Too found myself bewildered and confused. The valuations of the dot-com businesses and IT stocks seemed highly inflated. Pundits in the market and the media were pontificating on the new economy and giving convoluted justifications for what was approved to be sheer insanity. I wondered, was the entire world mad and I the only left the same, or was I insane and the world perfectly rational?

I had a client who had invested around 70 lakhs in different IT stocks in 1998 on his friend’s recommendations in 1999, his portfolio value was around Rs. 5 crores when he asked for my advice I told him, to sell as I thought that the PE multiples were very high and the valuations seemed for too stretched.

He did not do so and six months later when we met he informed me that the portfolio value was around Rs. 6 crores. Once again he asked me what he should do I was a bit embarrassed by the question, as I knew that he was, not asking for advice. but telling me indirectly that I was not in sync with the markets. I still insisted that he sell but he did not sometimes later the portfolio value went up to Rs. 8 crores.”

then the author explains why they 3 times give the wrong advice and his friend portfolio value is growing continuously.

the author says, ” this was the frustration I had to go through, of being in the investment business and not able to advise clients correctly. there were times I had sleepless nights fearing that the world was going too fast for me to understand. I doubted my abilities, my competencies, and my knowledge. (Stocks to Riches Chapter 4)

The inability to understand the madness added to the frustration. In fact, I lost quite a few clients as they thought that I was too conservative and not in tune with the new economy.”

then the author tries to find out the answer, for the above going wrong, why this happens

the author says, ” find an answer to this question I did some serious soul searching. my quest led to a fledging little know field called behavioral finance. ”

then the author explains, how emotions change and he is right with his decision, the only people, driven by their emotions. to understand this, the author gives good examples of true stories

the author says, ” this is a true story of a friend who ran a coaching class with one of his colleagues they started off well and within a couple of months they were full to capacity after six months, few students complained to my friend about his colleague’s rude behavior.

The allegation was that he was very short-tempered and arrogant. they wanted him removed or else they would discontinue the classes. My friend was worried. this colleague was his partner and he could not be removed. Moreover, he was a brilliant professional and an able tutor.

After a couple of weeks, the colleague fell ill and was absent for some time. the students were very happy. they thought that they had been successful in removing him.

one day my friend learned that the colleague had a brain tumor and needed an operation. this news shocked my friends, as now his partner would be out of action for quite some time. He informed the students of this calamity. the students were stunned and this shock changed their attitude. Hatred and resentment gave way to empathy and love. they visited him at the hospital and took him flowers. they repented their stand and prayed for his early recovery so that he could come back to teach.”

then the author told, what is the purpose behind this story.

the author says, ” purpose of this story is to understand that is humans we are emotional beings and our behavior and decisions are guided by our emotions. Frequently emotions prompt us to make decisions that may not be in our rational financial interest. Indeed decisions that enrich us emotionally may impoverish us financially.” (Stocks to Riches Chapter 4)

Behavioral finance is the study of how emotions and cognitive errors can cause disasters in our financial affairs.

then the author explains, Classical economic theory vs behavioral economic theory.

Classical Economic theory V/S Behavioural Economic theory:-

the author says, ” Classical theory talks about the efficiency of the markets and people making rational decisions to maximize their profits. It assumes that the markets are efficient and no one can take advantage of its movements. It also assumes that humans are rational beings and will act to maximize their goals.

However behavioral economists believe that the markets are inefficient and human beings are not rational beings.”

then the author, give the examples

the author says, ” Consider the examples if you and I were walking down a busy street in Colaba and you said you saw Rs. 5 coins on the road. I would say it is impossible. so many people walk this read and the markets being efficient someone would have definitely picked it up.

But in reality, we do come across such instances. this shows that the markets are not as efficient as they seem to be further, if we assume that people make rational decisions to maximize profits then how do we explain people giving to charities or throwing a party to celebrate a birthday or an anniversary?

Definitely, this is not about maximizing profits by rational people.

here’s another example of how irrational we can be. the acronym Tips:- stand for To Insure prompt service

If TIPS ensures good service we should be tipping before the service starts. Yet, we give tips at the end of the meal. We even give tips when the service is substandard. (Stocks to Riches Chapter 4)

Tipping is more a custom, we do it mechanically unaware that we are behaving irrationally. yet, in economic theory we are rational beings always intent on maximizing our economic status. this is a common mistake we make without realizing its pure economic implications.”

after this, the author explains behavioral finance and why we react like this.

the author says, ” Behavioural finance researchers seek to bridge the gap between classical economics and psychology to explain how and why people and markets do what they do. Behavioral finance raises a couple of important issues for investors. the first is whether or not it is possible to systematically exploit irrational market behavior when it occurs.

The second issue is how to avoid making sub-optimal decisions as an investor. the goal is to close the gap between how we actually make decisions and how we should make decisions.

  • Hold on to stocks, that is crashing
  • Sell stocks that are rising
  • Ridiculously overdue and Underdue stocks
  • jump in late and buy stocks that have peaked in a rally just before the price declines.
  • Take desperate risks and gamble wildly when our stocks fall.
  • Avoid taking the reasonable risk of buying promising stocks, unless there is an absolutely ‘ assured ‘ profit.
  • Never find the right price to buy and sell stocks.
  • Prefer fixed income overstocks.
  • Buy when we have to sell and sell because others are selling.

then the author explains, how psychology plays a wonderful role.

the author says, ” Psychology can play a strategic role in the financial markets, a fact that is being increasingly recognized.

Students and proponents of behavioral finance create investment strategies that capitalize on irrational investor behavior. They seek to identify market conditions in which investors are likely to overreact or under react to new information,

These mistakes cause underpriced or overpriced securities. The goal of behavioral finance strategies is to invest in or disinvest from these securities before most investors recognize their error, and to benefit from the subsequent jump or fall in prices once they do.”

then lastly author gives the three sources of Alpha for superior performance.

i think you should read this in the book, for buying the book, visit the following link

 

so this is all about the Introduction of behavior finance, from chapter 4 of the book Stocks to riches.

Investment strategy:- Stocks to Riches Chapter 2

Hello friends, in today’s blog, we see Investment strategy from the book Stocks to riches chapter 2, this book was written by value investor Parag Parikh. so in this chapter 2, we see investment strategy and the difference between investment and speculation. so let’s see one by one strategy.

Previous Chapter 1

Investment Strategy: Investment and Speculation

Investment strategy:- Stocks to Riches Chapter 2

In this chapter, the author explains investment strategy and the difference between investment and speculation.

the author says, ” Investment strategy is the first issue that investors should consider. Investing is an act of faith, a willingness to postpone present consumption to save for the future, thus investing for the long term is central to the achievement of optimum returns for the investor.

there are two sources of returns in the stock markets:-

  1. Fundamentals are represented by earnings and dividends.
  2. Speculation is represented by the market’s valuation of these fundamentals.

then the author ( Parag Parikh) explains in detail above two sources of return.

the author says,” the first is reliable and sustainable over the long run; the second is dangerous and risky. these lessons of history are central to the understanding of investing. these two sources of return could be further classified into cash flow and capital gains.”

After this, the author explains what is Cash flow and how we have to consider ourselves.

Cash Flow concept:-Investment strategy:- Stocks to Riches Chapter 2

the author says, ” When one believes in the fundamentals of investing, one is looking at the dividend payout of the company. these arise from the company’s earning potential, and are possible, only when the company has a positive cash flow. this cash flow is a product of the fundamentals or inherent strength, of the company, the sustainability of the business, and the robustness of the business model.

along with that, there are other variables such as the quality of the management, competitive market position, core competencies, etc. Investing in such companies enables the investor to earn a regular income over many years.”

then, the author explains investment value.

the author says, ” the investment value of a stock is the present worth of all the dividends to be paid upon it. this is best explained by John Burr Williams, ” A stock is worth only what you get out of it. A stock derives its value from its dividends, A cow for her milk, a hen for her eggs, bees for their honey, and stocks for their dividends.”

then the author explain capital appreciation,

the author says, ” the capital appreciation that takes place is seen primarily from the angle of bonus and right shares, which in turn increase the shareholding leading to higher dividends. As a result, the shareholding cash flow is augmented.

The rise in stock price is secondary as there is no intention of selling for capital gain. It is only satisfying to know that one can cash in on such a huge appreciation in times of need.

When investors follow this cash flow model of fundamental Investing. it is always based on the premise that over a long period, the stock markets will go up irrespective of the turbulence.

For them, the bull and bear markets are part of the investment process. on the contrary, they wait for a bear market, as they are able to get bargains there is also a strong belief that equity investments are the best hedge against inflation.” (Investment strategy:- Stocks to Riches Chapter 2)

You all know, nowadays, there is huge inflation, so if you want to beat inflation, then equity investment is best.

then the author talks about the Capital Gain concepts, and what is the benefit of that, and how can we use them for our purpose or goal in life?

Capital Gains Concept:-

The author says, ” When a stock goes up in value and one sells it at a profit, that gain is known as a capital gain. When people buy stocks in the belief that the prices will go up and they will be able to make a profit, it is known as speculation.

the price of a stock listed on the stock markets reflects the value of the fundamental. Speculators bet on the market value of the fundamentals. Now there are traders and speculators who buy and sell stocks according to their perception of the correct price of the stock based on the fundamentals. Say a company like Colgate is quoted at a price of Rs. 145.

A trader may feel that according to the fundamentals of the company Rs. 145 is a low price and that the stock could go up so he would buy that stock at Rs. 145. when it goes up he makes a profit, which is his capital gain, if it goes down he makes a loss.

Stock price movements take place for a variety of reasons and the investor is vulnerable to a host of uncertainties yet he is willing to take the risk. Here people are not looking at the fundamentals of a company.

they are looking at the stock price going up because of probable factors, Such as the fortunes of the company changing, expectations of higher profits a technological breakthrough, etc. they buy and sell stocks on information or an opinion or a rumor. the idea is to benefit from a price movement.

the inherent gambling instinct in a human being is responsible for the huge turnover in this kind of speculation.

speculation perse is gambling. In the stock markets, the other name for speculation is trading. it gives some credibility to the process and also has a different tax treatment ( the basic difference between speculation and trading is that in the former no delivery of the stocks is taken and in trading, the delivery is effected.

The capital gains model is based on the premise that stock markets always witness bull and bear phases; one follows the other. For speculators and traders, the trick is to take advantage of the ups and downs of the market,

Volatile stock price movements excite them, they follow the short-term approach. They strongly believe that since markets always fluctuate, a long-term strategy is useless. In fact, during the tech boom, I interacted with some experts and fund managers who held the firm view that the old ways of investing were out as the rules of the game had changed. (Investment strategy:- Stocks to Riches Chapter 2)

To buttress their claim they cited the example of how warren Buffett missed the tech boom. today I know for sure that all of them are nursing their wounds, this is what short-term success does.”

then the author explains why warren Buffett missed the tech boom, and why they are so successful.

the author says, ” Warren Buffett’s success till date is due to the fact that he would refrain from buying business he did not understand. He would buy stocks that were quoting a discount to their intrinsic value, and he would buy businesses from which he could visualize sustainable earnings over the long term. As the tech stocks did not fit in with these conditions he stayed away from them.”

Then the author gives the case study of Infosys companies.

I think you should read this case study, by buying this book from the following link

then the author says ” let’s sum up, let’s take the example of a cattle farm and a dairy farm. In a cattle form, the asset is the cattle, cattle are bred and reared to yield good value when they are sold to the slaughterhouse. this is what is speculation and trading. You buy on the asset, wait till the price, Increase, then sell it off in the market for a profit. this is how capital gains investing works.

on the other hand in a dairy farm, the asset is also cattle, here too the cattle are bred and reared but they are not sold to the slaughterhouse. the cattle have long-term use, they are used to obtain a regular supply of milk.

In both cases, the asset is the same but it is used differently one for meat and the other for milk. similarly, in the investment world, some people used stocks for capital gains by trading while others use them. Stocks for cash flow by investing long term.”

then the author explains the law of the Farm

The Law of the Farm:-

Then the author explains how to make money in the stock market, by applying the simple law of the farm.

the author says, ” Stock market investing is all about managing the rewards associated with the risks undertaken. without risk, there is no return. Invest you must but before that, you must bear in mind the law of the farm. You reap what you sow but the crop is also subjected to the changing seasons. the seeds have to endure summer, rain, winter, and spring before it turns into full-blown tree. Stock market investments also work that way. there are no shortcuts if we invest in the right stocks with the right business model and fundamentals, over the long run we are assured of optimum returns. However, to do this requires patience and we have to go through the ups and downs but it is important to stay the course. (Investment strategy:- Stocks to Riches Chapter 2)

Getting carried away y the greed of quick returns ultimately destroys wealth as it does not conform to the law of nature. Many of us forget that nature and society are one.”

then the author gives the best strategy of investment.

The Best Investment Strategy:-

the author says, ” There is nothing wrong with speculation as such on the contrary it is beneficial in two ways, Firstly without speculation untested new companies like Infosys, Satyam, and in earlier times companies like Reliance, would never have been able to raise the necessary capital for expansion.

the tempting chance of a huge gain is the grease that lubricates the machinery of innovation.

Secondly, the risk is exchanged every time the stock is sold and bought, but it is never eliminated. when the buyer buys a stock. He takes the primary risk that the stock will go down.

However, speculating can go wrong if people.

  • Do not understand the difference between investing and speculating.
  • Speculate without the right knowledge and skill.
  • Speculate beyond their capacity to take a loss ( that is called margin trading.)
  • The Greatest problem today is that most investors are acquiring speculative habits believing that they are investing.
  • The Attraction of quick money and the advent of the futures market have lured them to margin trading. for a number of people, this has become a full-time occupation due to the advent of the internet and online trading. This could be bad news especially when they are dealing with their life savings. “

then the author explains the risk Reward ratios.

Risk-Reward Balance:-

the author says, ” the important thing to remember is that investing is all about risk and Reward and vice versa.

the investor needs, to select the right balance when choosing investment vehicles and the strategy.

During the IT sector boom, the stock prices of IT companies were going up by leaps and bounds and people were buying such stocks at any price thinking that the price would go up. There was no rationality as to the value and the price. People were thus only buying risk, there was no effort to balance the risk-reward ratio. (Investment strategy:- Stocks to Riches Chapter 2)

We all know the fate of various IT Investors when the markets crashed. In March 2003, when the Iraq war was on, the markets were vert down and some of the stocks were available at ridiculously low valuations. the dividend yield was also very high. the price to earnings (P/E) ratios was attractive. This was the time to invest in Good Stocks as one would be only buying reward and the risk would be minimal. The risk-reward ratio would be in the investors favor.”

so this is all about how much you take risks with companies fundamentals, not speculative manner, that gives the high rewards.

then the author explains long-term investment.

the author says, ” Here are certain facts which prove the point that long-term investment is very rewarding and that patience is a virtue in equity markets. Three companies ( and there are several others), that have given excellent long-term returns to investors who bought stocks over a decade ago and held on to them, are Hindustan lever, hero honda, and Infosys.

The Hindustan lever has given a compounded annual growth rate ( CAGR) of 21 percent in returns for the last 13 years, whereas hero honda, has given 41 percent CAGR to shareholders on their investments during the same period. Infosys has delivered an astounding 79 percent annual return to shareholders since its listing 11 years ago. All these figures include dividends. as we can see this is higher than the returns available in any other investment avenue like bonds or bank deposits. (Investment strategy:- Stocks to Riches Chapter 2)

However, this does not mean that these stocks have only gone one way that is upwards.

They have had pretty serious declines at various points in time but despite that, the long-term result from owning them has been impressive.

The Hindustan lever has been falling for the last two years, Infosys had a very sharp decline after the bursting of the bubble in technology stocks and Hero honda also fell significantly in early 2003 when its quarterly sales slowed down.

Short-Term investment can also be rewarding for the speculator who is able to take risks and time the markets. Take the case of a speculator who had bought Infosys, at Rs. 2000 when the market started moving up and sold it when it went to is 13,800 within a year and a half. He made tremendous gains and he laughed at the investor who hold on to the stock since the beginning and got a return of 79 percent CAGR.

a Speculator could have short sold Hindustan lever at Rs. 210 in November 2003 and recovered it at 4,120 in august 2004 making a return that even a long-term investor in Hindustan lever would envy.

Speculators do make a killing, as some would have definitely done during the various periods of the boom and the bust cycles. the only rider is, can they do it consistently over time! A lot of speculators could have made more money than the long-term investor on the above stocks.

So it is different to say which strategy is good and which is bad. It depends upon the individual’s mental attitude, discipline, risk-taking ability, and patience.

from the above paragraph, some points conclusively prove

  1. Long-term investing can be very rewarding if you buy the right company at the right price.
  2. a stock can decline significantly in the short run and yet give a decent long-term return.
  3. Short-term investing ( speculating) can also be very rewarding if you are able to time the markets and take advantage of short-term volatility.

 

As we can be seen from the above table even though the net profit of Infosys has grown it 43 percent CAGR, 2000-2004 the market capitalization has fallen by 14 percent CAGR in the same period.

This is the impact on investors when a good business is bought at irrational prices. the P/E ratio has continuously declined. (Investment strategy:- Stocks to Riches Chapter 2)

So if one had bought the stock at a higher price in 2000 he would be losing money in spite of the company showing improved performance, this is the risk one takes when one is speculating.

Most of the IT experts and fund managers ignored Benjamin graham’s words of warning. ” Obvious prospects for physical growth in a business do not translate into obvious profits for investors.

In today’s changing times there is so much uncertainty that looking at the long-term approach seems unviable. Hence the stock markets have become the bedrock of brute speculation.

this is the reason for so much volatility. It is also turning long-term investors into short-term punters. this is how the investment world works today. If you want to be a successful investor there are three ways of investing Chapter 3 looks at the best way to invest.

so this is all about chapter 2 from the book Stocks to riches by Parag Parikh

If you want to earn a lot of money in the stock market, you must read this book. This is only of my favorite book, so when I was looking I am away from my value investing strategy, then I read this book, and again set my mindset as a value investor.

this book explains wonderful investment strategies, be read continuously.