This is a great check list of 10 habits, impulses and tendencies you steer clear of in order to keep your investments healthy.
1. Don't be arrogant
The market teaches humility and that is how you must approach it. As soon as you believe you know why the market acts the way it does, you will be proven wrong. Arrogance can kill a portfolio. You must be able to admit defeat and preserve enough capital to fight again.
Following point and figure charts, which depict the battle between supply and demand, helps keep you out of the 'I know why' attitude of investing.
2. Don't wait until you feel comfortable to buy when a sector reverses up
Falling into the waiting trap is a great way to ensure that you buy the stock at a higher price. When sectors reverse up from oversold levels, it is often when the news is the most dire.
Conventional wisdom would suggest this is the last place in the world you would want to invest. Buying at this time is gut wrenching, but to be successful you must act with complete confidence.
As the sector moves higher, the comfort level increases. If you use comfort level as your guidance, however, you will for sure leave a lot of money on the table, or worse, buy as the sector peaks.
3. Don't be afraid to buy strong stocks
Don't avoid stocks just because they have gone up. Doing so will keep you out of the long-term winners. In the United States, for example, this mentality would have kept you out of General Electric, which was up 188 per cent between January 1995 and December 1997 only to see it rally another 96 per cent by the end of 2000. It also would have kept you out of Cisco, which was up 376 per cent between January 1995 and December 1997, and then it moved up another 312 per cent by the end of 2000. These are only two examples, but there are many others.
More important than how much the stock is up is its supply and demand relationship. By evaluating the point and figure chart, you can gain insight into this relationship and whether or not the stock is likely to move higher. Stocks that double can easily double again. Don't miss out on these great opportunities.
4. Don't sell a stock simply because it has gone up
Doing this cuts profits short. Buying a stock right is only half the battle. You have to be able to sell it right to win the war. Just because a stock has rallied 30 per cent or 50 per cent, don't be tempted to take your trade off for that reason alone.
Consider trimming the position and leave part on the table to continue in the uptrend. Let profits run.
5. Don't buy stocks in extended sectors because 'it's different this time'
On the surface, the stock market appears different all the time. The leadership changes: in come new stocks into the Nifty 50, and then out they go. Small-cap stocks outperform for a while, then it's back to the large caps.
However, the underlying forces that drive the stock market are always the same. They are true and time-tested and do not change. They are supply and demand. That's why buying sectors that are extended (overbought) will not be different this time.
6. Don't try to bottom fish a stock in a downtrend
'The trend is your friend' is a true statement. So don't go against it without some inkling that the trend has changed.
Bottom fishing a stock in a downtrend is the opposite of being afraid to buy strong stocks. Do not buy a stock just because it fell sharply. You want to buy a stock that is likely to move higher, not one that is not likely to fall further.
At a minimum, wait for the stock to show a sign that demand is back in control and suggesting higher prices. That may be a simple buy signal on the chart or a reversal back to the upside after holding an area of support. Also remember why you initiated the position. Be careful not to let a trade turn into something else.
7. Don't buy a stock simply because it is a 'good value'
These days, value is in the eyes of the holder, and therefore it is a subjective term at best. If a stock has become a good value, ask why. This is important, because a stock can stay a good value by not moving for the next decade, or worse, become a better value by dropping another 20 per cent.
The true value of a stock is determined by its capital appreciation potential, not numbers on a balance sheet. The basis for capital appreciation lies in the supply and demand relationship of the stock. Appreciation can occur only if demand grows stronger for the stock and buyers are willing to pay a higher price. Watch the point and figure charts to determine if a stock is likely to move higher in price and become a good value.
8. Don't hold on to losing stocks and hope they come back
Hope is eternal, but your portfolio is not. Holding on to a losing stock is the best way to let your losses run. Combine this mistake with selling a stock that has gone up and you can create a portfolio of dogs.
When buying stocks, there will always be some losers: Count on it. However, how you manage that loss often determines the success or failure of the overall portfolio. Keep losses small so that you have the capital to play again. Hanging on to losing positions, hoping that they will come back, can be deadly.
A $50 stock that is stopped out at $40 is a 20 per cent loss. It's a bad trade, but it is manageable. In order to recoup that loss you would have to make 25 per cent on a $40 stock. What if you held on to that $50 stock, hoping that strong earnings would come in and turn it around, but instead it continued lower to $25?
Finally, you decide to exit, but now it takes a 100 per cent return from a $25 stock just to get back to even. Those results are hard to find, and if you are able to find one, you don't want to waste it on getting back to even
Learn to recognize your losing positions for what they are. If a stock cannot trade above its support line or is not outperforming the averages, find one that is and swap it.
9. Don't pursue perfection
There are two types of mistakes to discuss here. The first is the constant belief that there is a better system out there, and you need to find it.
Using a new system to invest each week will not get you to your goal. You will become good at nothing and moderate to bad at everything. To be good requires that you stay focused, disciplined, and skilled at whatever methodology you choose.
You need to have the strength of conviction in your chosen discipline to learn from mistakes rather than to run away from them and find another methodology. There is no Holy Grail in investing.
The second mistake is to wait for the perfect trade. There is no such thing. If you only buy stocks that have all positive attributes you will maintain a portfolio of cash. Rarely, if ever, do you find a stock that has all the pluses on its side.
Look for the big ones like relative strength, trend, and signal. Also remember that 80 per cent of the cause of price movement in a stock is based on the market and sector. You are better off being approximately right than precisely wrong.
10. Don't do anything based on a magazine cover
Following the hot news that appears on magazine covers is a shortcut to the poor-house. Why should you follow the advice of someone who has just moved from the society pages to the business section?
Source
Showing posts with label Stock markets. Show all posts
Showing posts with label Stock markets. Show all posts
Sunday, April 26, 2009
Thursday, February 12, 2009
The worst is yet to come
Let's begin with some good news. Large companies with proven track records haven't disappointed the market. In fact, the third-quarter results of Reliance Industries, Infosys, ITC and ICICI Bank have been either along expected lines, or better than the Street's estimates. But that's not true for the rest of India Inc. The earnings of most mid- and small-cap companies have deteriorated alarmingly.
The net sales of 450 firms, which declared Q3 results till 23 January, have grown at a healthy 19.34% compared with the same quarter in the previous fiscal. But their net profits have fallen by 22.15% during the same period. The steep drop in profits is worrying because these companies registered a robust 40.29% growth in profits in the third quarter of 2007-8. The real problem is with the small and mid-sized firms, whose net profits in Q3 2008-9 have fallen by a massive 39%.
"Most large corporates haven't really disappointed us. The stress is more pronounced in case of midcap firms, where some of the results were worse than the already toneddown expectations," says Gaurav Dua, head of research, Sharekhan.
So, should you invest across stocks as the indices fall to attractive levels? Or should you look only at blue chips? To answer these questions, one needs to figure out what is likely to happen in the next few quarters.
The third quarter of 2008-9 was expected to be one of the weakest in recent years. By November 2008, analysts had scaled down their expectations and the markets had discounted the prices of most stocks. Profit margins were under pressure during Q2 due to inventory losses as most companies were saddled with raw materials purchased at the peak of the commodity cycle in July-August 2008.
Sadly, there may not be any respite in Q4. Reasons Dua: "Though some of the companies will begin to show relief on margins due to lower raw material costs, the demand environment will remain muted." This will happen because of several factors. Fragile sentiments, cash crunch and falling exports will take their toll on the Indian companies. As firms curtail investments, cut costs and reduce production, it will lead to a slump in economic activity.
"Industrial growth will slow down to 2.5% this year, against 9% in the previous fiscal. Given that the business confidence will remain low, the slowdown will spill over to 2009-10," predicts Anubhuti Sahay, associate economist at the Standard Chartered Bank.
In such a scenario, even sectors such as IT and banking, which were insulated from the drop in demand so far, can face problems. Commenting on the Q3 results, Wipro chairman Azim Premji said, "We are living in tough times; the macro-economic challenges are impacting businesses across segments." Both Infosys and Wipro have cut their annual guidance.
"The revenue visibility across companies appears to be, at best, limited to a quarter," says Abhiram Eleswarapu, analyst at BNP Paribas. Therefore, in the case of IT stocks, existing and potential investors need to wait and watch before taking investment decisions.
The same is true for banks, which posted an amazing profit growth of over 30% in Q3. But this is not likely to sustain. Moderate credit growth, lower interest rates on government bonds and rising NPAs will put pressure on earnings. "We foresee a slowdown in banks' earnings over the next few quarters as the G-Sec gains become muted," says Sonam Udasi, vice-president of research at Brics Securities.
Analysts say that despite low interest rates and the government's intention to trigger a demand-led growth cycle, the situation might improve only in the second half of 2009-10. "Once the impact of the interest rate cycle is passed on and firms begin to reduce their working capital requirement, the bottom line growth is expected to improve," says Sankaran Naren, CIO, equity, ICICI Prudential AMC.
Among sectors, while realty and commodities might slip, FMCG and pharma may continue with their growth story. Cash-rich companies with low or negligible debt are likely to outperform. "Investors should avoid aggressive or leveraged sectors, and focus on companies with excellent financial and operational management," concludes Naren.
Source
The net sales of 450 firms, which declared Q3 results till 23 January, have grown at a healthy 19.34% compared with the same quarter in the previous fiscal. But their net profits have fallen by 22.15% during the same period. The steep drop in profits is worrying because these companies registered a robust 40.29% growth in profits in the third quarter of 2007-8. The real problem is with the small and mid-sized firms, whose net profits in Q3 2008-9 have fallen by a massive 39%.
"Most large corporates haven't really disappointed us. The stress is more pronounced in case of midcap firms, where some of the results were worse than the already toneddown expectations," says Gaurav Dua, head of research, Sharekhan.
So, should you invest across stocks as the indices fall to attractive levels? Or should you look only at blue chips? To answer these questions, one needs to figure out what is likely to happen in the next few quarters.
The third quarter of 2008-9 was expected to be one of the weakest in recent years. By November 2008, analysts had scaled down their expectations and the markets had discounted the prices of most stocks. Profit margins were under pressure during Q2 due to inventory losses as most companies were saddled with raw materials purchased at the peak of the commodity cycle in July-August 2008.
Sadly, there may not be any respite in Q4. Reasons Dua: "Though some of the companies will begin to show relief on margins due to lower raw material costs, the demand environment will remain muted." This will happen because of several factors. Fragile sentiments, cash crunch and falling exports will take their toll on the Indian companies. As firms curtail investments, cut costs and reduce production, it will lead to a slump in economic activity.
"Industrial growth will slow down to 2.5% this year, against 9% in the previous fiscal. Given that the business confidence will remain low, the slowdown will spill over to 2009-10," predicts Anubhuti Sahay, associate economist at the Standard Chartered Bank.
In such a scenario, even sectors such as IT and banking, which were insulated from the drop in demand so far, can face problems. Commenting on the Q3 results, Wipro chairman Azim Premji said, "We are living in tough times; the macro-economic challenges are impacting businesses across segments." Both Infosys and Wipro have cut their annual guidance.
"The revenue visibility across companies appears to be, at best, limited to a quarter," says Abhiram Eleswarapu, analyst at BNP Paribas. Therefore, in the case of IT stocks, existing and potential investors need to wait and watch before taking investment decisions.
The same is true for banks, which posted an amazing profit growth of over 30% in Q3. But this is not likely to sustain. Moderate credit growth, lower interest rates on government bonds and rising NPAs will put pressure on earnings. "We foresee a slowdown in banks' earnings over the next few quarters as the G-Sec gains become muted," says Sonam Udasi, vice-president of research at Brics Securities.
Analysts say that despite low interest rates and the government's intention to trigger a demand-led growth cycle, the situation might improve only in the second half of 2009-10. "Once the impact of the interest rate cycle is passed on and firms begin to reduce their working capital requirement, the bottom line growth is expected to improve," says Sankaran Naren, CIO, equity, ICICI Prudential AMC.
Among sectors, while realty and commodities might slip, FMCG and pharma may continue with their growth story. Cash-rich companies with low or negligible debt are likely to outperform. "Investors should avoid aggressive or leveraged sectors, and focus on companies with excellent financial and operational management," concludes Naren.
Source
Wednesday, February 11, 2009
Sub-prime crisis is the flip side of a booming economy
Meaning of Sub-Prime Mortgage
In a mortgage market, borrowers are categorised either as ‘prime’, which indicates their good credit-worthiness, based on their sound track record; or as ‘sub-prime’, meaning that their track record in repaying loans is below par.
Many mortgages issued in recent years in the US were sub-prime. There was little or no down payment made for loans, and they were issued to households with low incomes and assets, or with troubled credit histories. Thereafter, when home prices in the US began to decline in 2006-07, mortgage delinquencies rose, and securities backed by sub-prime mortgages that were widely held by financial institutions, lost most of their value. This resulted in sharp decline of the capital of many banks, creating a credit crunch around the world. This article focuses on various facets of the aforesaid credit cycle.
Reasons Attributable to Current Crisis
Various reasons can be attributed to the current crisis, that are varied, complex and have emerged over a number of years. Some of these are: imperfect monetary policy and lack of government regulation; poor judgment of credit-worthiness of borrowers by lenders; borrower’s inability to re-pay principal amount and installments of mortgage availed; speculation and overbuilding during the boom period; distribution of risky financial products in mortgage market.
The lack of government regulation refers to the lack of government’s foresight to analyse the consequences of the various mortgage products that were offered at low interest rates and with many other features that encouraged borrowers to avail risky loan with much ease. Much can be attributed to political pressure, imposed by the US federal government on banking and financial system to provide houses at an affordable price to Americans, to raise their standard of living. In addition to that, self-regulation of investment banks also contributed to the crisis, as conceded by Securities and Exchange Commission (SEC).
It is pertinent to note that the period from 1996 to early 2005 was a period of innovation in house loan sector, with adequate boom to sustain demand and supply balance. But in the enthusiasm to go after the lucrative sub-prime market and create an artificial buying power for borrower, lenders introduced newer riskier products with insufficient asset value as collateral. They sought higher yields without an adequate appreciation of risk and by not conducting proper financial due diligence.
As such, top investment banks in the US significantly increased their financial risk and their vulnerability to the declining value of mortgage-backed securities (MBS). As a result, investment banks across the world incurred about $30 billion in debts leading to the global credit crunch.
As, later on, when this housing bubble busted, three out of five large investment banks of the US failed, augmenting instability in global financial system.
Understanding the Vicious Cycle
In cases where the person or entity, availing loan from a bank on account of good credit rating, sound track record and ability to repay, in-turn offers and extends loan facility to individuals or entities, whose ability to service the debt and principal amount is poor, such loan facilities are categorised as ‘sub-prime loans’. Therefore, individuals or entities, who do not have a good credit rating and to whom the bank would not have ordinarily given a house loan, now have the advantage of availing the same through intermediate lenders, ie persons or entities, who secure loan for onward distribution to such persons at a much higher rate of interest than the rate at which the loan is originally borrowed, by such intermediate lenders, from the bank. This higher rate is referred to as the ‘sub-prime rate’ and this house loan market is referred to as the ‘sub-prime house loan’ market.
The motivation for the intermediate lenders is to act on the incentive theory of extending the house loan facility to large number of individuals and/or entities, and thereby hedge the underlying risk on to them by reducing the threat of default. What seems to flow from the foregoing is that even if few of the borrowers (ie. individuals and/or entities) default, the overall position would not be affected much, and the intermediate lender may end-up making a neat profit.
A very interesting fact to notice next is that such a lender, who extends loan facilities in the sub-prime house loan market, does not stop here. That is to say, it does not wait to realise the principal and the interest in respect of the sub-prime house loans, so that it can then r-pay its loan (that such lenders (being the prime borrower) had originally availed from the bank (being the prime lender). Here the question that may come to one’s mind is: What makes these lenders feel that they could take on the extra risk introduced by these financial products? and the answer lies in the booming “credit derivative market” that has made risk transfer easy! The lender goes ahead and securitizes these sub-prime loans, whereby the sub-prime loans are converted into financial securities that would yield a certain rate of interest.
These financial securities are further sold to big institutional investors, thereby creating a secondary market for mortgages (where those issuing mortgages were no longer required to hold them till maturity. Many investment banks (which are in the business of sub-prime mortgaging) and other financial institutions sell these complicated financial securities, backed by risky debt to institutional investors. As a result of this sale, the principal and the interest payable by the sub-prime borrowers through equated monthly instalments (EMIs) to the intermediate lender, is passed onto these institutional investors, who have purchased these securitized loans.
It may now be worthwhile to analyse few figures regarding MBS. The total amount of MBS issued tripled from 1996 to 2007 at $7.3 trillion. The securitized share of sub-prime mortgages, which is passed to third party by investors through MBS, increased from 54% in 2001 to 75% in 2006.
It is to be noted that the US kept its interest rates very low for a very long time, thus, encouraging Americans to go for housing loans or mortgages, and further, encouraged them to take on bigger loans. As a result, during 2006, 22% of houses purchased (1.65 million units) were for investment purposes. While houses, had not traditionally been treated as investment options, this behavioral change during the housing boom due to aforesaid factors led to houses being refinanced to repay the original loan and book profits due to continuous increase in value.
Another very important feature of these sub-prime house loans is that such loans are given on a floating interest rate (meaning that the rate of interest to be charged is not fixed but fluctuating) except for a certain initial period, say two-three years. This gives the borrower leverage for the initial period, where he repays the loan at a fixed interest rate EMI under fixed rate mortgages (FRM), but once that initial period expires, the borrower will have to repay the remaining portion of the loan at a floating interest rate EMIs under adjustable rate mortgages (ARM). In the event of the interest rates going up due to government intervention or otherwise, the interest rate on floating rate house loans would also soar, thereby increasing the EMIs required to be paid to service the loans.
Consequently, sub-prime borrowers, who already have a bad credit rating and unsound financial status, may not be able to bear the pressure of mounting interest rates, and may, thus, start defaulting. Once more and more sub-prime borrowers default, payments to the institutional investors, who had bought the MBS, stop, leading to huge financial losses.
One pertinent question that may arise is, “Why default became a preferable option for the borrowers?” The answer is simple enough, the sub-prime house owners began to default not only as they could no longer afford to pay the inflating EMIs, but also because they were fully aware of a sharp decline in the value of the house (being the only collateral for the loan that they had taken). Earlier, this easy availability of credit and house price explosion led to a housing boom, which eventually culminated into a surplus of unsold houses. This surplus of unsold houses led to an unprecedented increase in the supply of houses, leading to a sharp fall in the value of houses in the US. In very simple words, for the borrower, his liability exceeded the value of his mortgaged asset (i.e. the house), and thereby, leaving him with negative liquidity in the house. Thus, declaration of bankruptcy seemed to be a better alternative than servicing of the loan through inflated EMIs for securing the house, whose value had already diminished immensely.
By September 2008, the average US housing prices had declined by over 20% from their mid-2006 peak. As of March 2008, an estimated 8.8 million borrowers, constituting approximately 10.8% of all home-owners, had negative equity in their houses, the figure that would have substantially increased by now. Consequently, borrowers in this situation had an incentive to “walk away” from their mortgages and abandon their houses, even though doing so, would potentially result in damaging their credit rating and reputation for a number of years. The potential reason that prompted the borrowers to abandon their houses and “walk away” from the mortgage obligation could be, that in the US the house mortgages are non-recourse loans; ie once the creditor (the lender) has control and possession of the mortgaged property, such a creditor does not have any further claim against the defaulting borrower’s income and/or other assets. As more and more borrowers opted to default and “walk away” by declining to service the loans that they had obtained, there was a sudden spurt in the supply of houses for re-sale. This placed a phenomenal downward pressure on housing prices, which further added to reduction of homeowners’ equity. The decline in mortgage payments also reduced the value of MBS, which eroded the net worth and financial health of banks and the institutional investors, who had invested in such MBS.
These banks and the institutional investors were hit by an unstoppable flood of such defaults, adversely and severely affecting their net-worth. Their MBS were almost worthless as real estate prices crashed and reached to rock bottom levels, breaking the backs of these financial entities, and thus, leading to the current meltdown, not only of the US economy but, of the global economy.
The problem worsened because the individuals and the entities (the intermediate lenders) giving out sub-prime house loans could easily securitize the same and quickly get rid of it from its balance sheet. Hence, the intermediate lenders do not take the risk of the loan going bad. The bank (being the prime lender) is also repaid by the intermediate lenders (who are the prime borrowers) along with interest, does not have any inhibitions in subsequent lending of money. Thus, the ultimate risk is passed on to the institutional investors, who buy the mortgaged backed financial securities issued for securitizing the loan.
Adverse Effect on Stock Markets in India
This recessionary trend in the US has had its impact, not only on the stock markets in India, but on other Asian markets as well. The institutional investors, who had invested in securitised paper from the sub-prime house loan market in the US, witnessed their investments melting into irreversible losses. But as most big investors have a certain fixed proportion of their total investments invested in various parts of the world, therefore, once investments in the US turned into irreversible losses, these big investors started liquidating their investments in emerging markets, like India, to maintain equilibrium and to fund the working capital requirements of their respective establishments in the US.
Since the volume of selling in such emerging markets (including the Indian stock exchanges) rose much higher than the amount of buying, in India both the Sensex and Nifty began to tumble to the dismay of all the investors.
Conclusion
To sum it up, it is clear that the banks and institutional investors have to look at secured approaches to manage credit risk, given the weakness of the existing approach. There is a need to liquidate the inventories of newly built houses (real estate) in the US, such that the price deflation comes to an end and house loan market, as much as possible, stabilises. Undoubtedly, it will initially incur huge losses for the economy but gradually the US will be able to get back on tracks and attain the state of normalcy. Further, there is a need to end the uncertainty prevailing around, as to how bad this slowdown could get and how long it’s going to last.
Lastly, as we know, the US Federal Government is on a move and is making all efforts to bail out different sectors of the US economy, most importantly the banking sector, but it cannot, conclusively, be assured that this infusion of liquidity into the banking sector by purchase of their bad debts, would quickly flow down into the US economy, as the banking sector may now be shy in lending having had an adverse experience with easy lending schemes. The banking sector, currently, is in a survival mode rather than dynamic mode, which suggests that the banks at this time would be very skeptical or hesitant in lending. Therefore, there is a clear need for the banks to develop a healthy equilibrium between continuous lending (so as to give an upward thrust to the economy by raising liquidity levels) and taking a careful approach in future lendings by judging, the credit-worthiness of the future borrowers, and real value of collateral being offered as security by the borrowers (so as to avoid further default and decline in its net worth).
Source
In a mortgage market, borrowers are categorised either as ‘prime’, which indicates their good credit-worthiness, based on their sound track record; or as ‘sub-prime’, meaning that their track record in repaying loans is below par.
Many mortgages issued in recent years in the US were sub-prime. There was little or no down payment made for loans, and they were issued to households with low incomes and assets, or with troubled credit histories. Thereafter, when home prices in the US began to decline in 2006-07, mortgage delinquencies rose, and securities backed by sub-prime mortgages that were widely held by financial institutions, lost most of their value. This resulted in sharp decline of the capital of many banks, creating a credit crunch around the world. This article focuses on various facets of the aforesaid credit cycle.
Reasons Attributable to Current Crisis
Various reasons can be attributed to the current crisis, that are varied, complex and have emerged over a number of years. Some of these are: imperfect monetary policy and lack of government regulation; poor judgment of credit-worthiness of borrowers by lenders; borrower’s inability to re-pay principal amount and installments of mortgage availed; speculation and overbuilding during the boom period; distribution of risky financial products in mortgage market.
The lack of government regulation refers to the lack of government’s foresight to analyse the consequences of the various mortgage products that were offered at low interest rates and with many other features that encouraged borrowers to avail risky loan with much ease. Much can be attributed to political pressure, imposed by the US federal government on banking and financial system to provide houses at an affordable price to Americans, to raise their standard of living. In addition to that, self-regulation of investment banks also contributed to the crisis, as conceded by Securities and Exchange Commission (SEC).
It is pertinent to note that the period from 1996 to early 2005 was a period of innovation in house loan sector, with adequate boom to sustain demand and supply balance. But in the enthusiasm to go after the lucrative sub-prime market and create an artificial buying power for borrower, lenders introduced newer riskier products with insufficient asset value as collateral. They sought higher yields without an adequate appreciation of risk and by not conducting proper financial due diligence.
As such, top investment banks in the US significantly increased their financial risk and their vulnerability to the declining value of mortgage-backed securities (MBS). As a result, investment banks across the world incurred about $30 billion in debts leading to the global credit crunch.
As, later on, when this housing bubble busted, three out of five large investment banks of the US failed, augmenting instability in global financial system.
Understanding the Vicious Cycle
In cases where the person or entity, availing loan from a bank on account of good credit rating, sound track record and ability to repay, in-turn offers and extends loan facility to individuals or entities, whose ability to service the debt and principal amount is poor, such loan facilities are categorised as ‘sub-prime loans’. Therefore, individuals or entities, who do not have a good credit rating and to whom the bank would not have ordinarily given a house loan, now have the advantage of availing the same through intermediate lenders, ie persons or entities, who secure loan for onward distribution to such persons at a much higher rate of interest than the rate at which the loan is originally borrowed, by such intermediate lenders, from the bank. This higher rate is referred to as the ‘sub-prime rate’ and this house loan market is referred to as the ‘sub-prime house loan’ market.
The motivation for the intermediate lenders is to act on the incentive theory of extending the house loan facility to large number of individuals and/or entities, and thereby hedge the underlying risk on to them by reducing the threat of default. What seems to flow from the foregoing is that even if few of the borrowers (ie. individuals and/or entities) default, the overall position would not be affected much, and the intermediate lender may end-up making a neat profit.
A very interesting fact to notice next is that such a lender, who extends loan facilities in the sub-prime house loan market, does not stop here. That is to say, it does not wait to realise the principal and the interest in respect of the sub-prime house loans, so that it can then r-pay its loan (that such lenders (being the prime borrower) had originally availed from the bank (being the prime lender). Here the question that may come to one’s mind is: What makes these lenders feel that they could take on the extra risk introduced by these financial products? and the answer lies in the booming “credit derivative market” that has made risk transfer easy! The lender goes ahead and securitizes these sub-prime loans, whereby the sub-prime loans are converted into financial securities that would yield a certain rate of interest.
These financial securities are further sold to big institutional investors, thereby creating a secondary market for mortgages (where those issuing mortgages were no longer required to hold them till maturity. Many investment banks (which are in the business of sub-prime mortgaging) and other financial institutions sell these complicated financial securities, backed by risky debt to institutional investors. As a result of this sale, the principal and the interest payable by the sub-prime borrowers through equated monthly instalments (EMIs) to the intermediate lender, is passed onto these institutional investors, who have purchased these securitized loans.
It may now be worthwhile to analyse few figures regarding MBS. The total amount of MBS issued tripled from 1996 to 2007 at $7.3 trillion. The securitized share of sub-prime mortgages, which is passed to third party by investors through MBS, increased from 54% in 2001 to 75% in 2006.
It is to be noted that the US kept its interest rates very low for a very long time, thus, encouraging Americans to go for housing loans or mortgages, and further, encouraged them to take on bigger loans. As a result, during 2006, 22% of houses purchased (1.65 million units) were for investment purposes. While houses, had not traditionally been treated as investment options, this behavioral change during the housing boom due to aforesaid factors led to houses being refinanced to repay the original loan and book profits due to continuous increase in value.
Another very important feature of these sub-prime house loans is that such loans are given on a floating interest rate (meaning that the rate of interest to be charged is not fixed but fluctuating) except for a certain initial period, say two-three years. This gives the borrower leverage for the initial period, where he repays the loan at a fixed interest rate EMI under fixed rate mortgages (FRM), but once that initial period expires, the borrower will have to repay the remaining portion of the loan at a floating interest rate EMIs under adjustable rate mortgages (ARM). In the event of the interest rates going up due to government intervention or otherwise, the interest rate on floating rate house loans would also soar, thereby increasing the EMIs required to be paid to service the loans.
Consequently, sub-prime borrowers, who already have a bad credit rating and unsound financial status, may not be able to bear the pressure of mounting interest rates, and may, thus, start defaulting. Once more and more sub-prime borrowers default, payments to the institutional investors, who had bought the MBS, stop, leading to huge financial losses.
One pertinent question that may arise is, “Why default became a preferable option for the borrowers?” The answer is simple enough, the sub-prime house owners began to default not only as they could no longer afford to pay the inflating EMIs, but also because they were fully aware of a sharp decline in the value of the house (being the only collateral for the loan that they had taken). Earlier, this easy availability of credit and house price explosion led to a housing boom, which eventually culminated into a surplus of unsold houses. This surplus of unsold houses led to an unprecedented increase in the supply of houses, leading to a sharp fall in the value of houses in the US. In very simple words, for the borrower, his liability exceeded the value of his mortgaged asset (i.e. the house), and thereby, leaving him with negative liquidity in the house. Thus, declaration of bankruptcy seemed to be a better alternative than servicing of the loan through inflated EMIs for securing the house, whose value had already diminished immensely.
By September 2008, the average US housing prices had declined by over 20% from their mid-2006 peak. As of March 2008, an estimated 8.8 million borrowers, constituting approximately 10.8% of all home-owners, had negative equity in their houses, the figure that would have substantially increased by now. Consequently, borrowers in this situation had an incentive to “walk away” from their mortgages and abandon their houses, even though doing so, would potentially result in damaging their credit rating and reputation for a number of years. The potential reason that prompted the borrowers to abandon their houses and “walk away” from the mortgage obligation could be, that in the US the house mortgages are non-recourse loans; ie once the creditor (the lender) has control and possession of the mortgaged property, such a creditor does not have any further claim against the defaulting borrower’s income and/or other assets. As more and more borrowers opted to default and “walk away” by declining to service the loans that they had obtained, there was a sudden spurt in the supply of houses for re-sale. This placed a phenomenal downward pressure on housing prices, which further added to reduction of homeowners’ equity. The decline in mortgage payments also reduced the value of MBS, which eroded the net worth and financial health of banks and the institutional investors, who had invested in such MBS.
These banks and the institutional investors were hit by an unstoppable flood of such defaults, adversely and severely affecting their net-worth. Their MBS were almost worthless as real estate prices crashed and reached to rock bottom levels, breaking the backs of these financial entities, and thus, leading to the current meltdown, not only of the US economy but, of the global economy.
The problem worsened because the individuals and the entities (the intermediate lenders) giving out sub-prime house loans could easily securitize the same and quickly get rid of it from its balance sheet. Hence, the intermediate lenders do not take the risk of the loan going bad. The bank (being the prime lender) is also repaid by the intermediate lenders (who are the prime borrowers) along with interest, does not have any inhibitions in subsequent lending of money. Thus, the ultimate risk is passed on to the institutional investors, who buy the mortgaged backed financial securities issued for securitizing the loan.
Adverse Effect on Stock Markets in India
This recessionary trend in the US has had its impact, not only on the stock markets in India, but on other Asian markets as well. The institutional investors, who had invested in securitised paper from the sub-prime house loan market in the US, witnessed their investments melting into irreversible losses. But as most big investors have a certain fixed proportion of their total investments invested in various parts of the world, therefore, once investments in the US turned into irreversible losses, these big investors started liquidating their investments in emerging markets, like India, to maintain equilibrium and to fund the working capital requirements of their respective establishments in the US.
Since the volume of selling in such emerging markets (including the Indian stock exchanges) rose much higher than the amount of buying, in India both the Sensex and Nifty began to tumble to the dismay of all the investors.
Conclusion
To sum it up, it is clear that the banks and institutional investors have to look at secured approaches to manage credit risk, given the weakness of the existing approach. There is a need to liquidate the inventories of newly built houses (real estate) in the US, such that the price deflation comes to an end and house loan market, as much as possible, stabilises. Undoubtedly, it will initially incur huge losses for the economy but gradually the US will be able to get back on tracks and attain the state of normalcy. Further, there is a need to end the uncertainty prevailing around, as to how bad this slowdown could get and how long it’s going to last.
Lastly, as we know, the US Federal Government is on a move and is making all efforts to bail out different sectors of the US economy, most importantly the banking sector, but it cannot, conclusively, be assured that this infusion of liquidity into the banking sector by purchase of their bad debts, would quickly flow down into the US economy, as the banking sector may now be shy in lending having had an adverse experience with easy lending schemes. The banking sector, currently, is in a survival mode rather than dynamic mode, which suggests that the banks at this time would be very skeptical or hesitant in lending. Therefore, there is a clear need for the banks to develop a healthy equilibrium between continuous lending (so as to give an upward thrust to the economy by raising liquidity levels) and taking a careful approach in future lendings by judging, the credit-worthiness of the future borrowers, and real value of collateral being offered as security by the borrowers (so as to avoid further default and decline in its net worth).
Source
Tuesday, December 16, 2008
10 great investing rules from history
Remember that old adage to the effect that those who don't learn lessons from history are bound suffer avoidable hardship?
Learning the important lessons that history of investment offers, will rev up your investing profits. . .
1. Put all your eggs in one basket and watch that basket!
This saying comes from Mark Twain, but has been applied to stock market investment more or less verbatim by both John Maynard Keynes and Warren Buffett. Modern portfolio theory suggests that one can reduce risk by diversification.
However, if you were an active investor you would do better to concentrate your shareholdings in a limited number of companies which you feel you understand. This can actually reduce risk.
2. When the ducks quack, feed them
This is an old Wall Street adage relating to initial public offerings. Investment bankers are out to make money and will sell the public anything within the bounds of the law.
Research suggests that, in general, IPOs rocket upwards on the first day's trading but tend to under perform comparable companies over a three-year period. Since small investors don't receive fair allocations of the best IPOs but are landed with the duds, they should avoid the new issue market entirely.
3. Markets make opinions, not the other way round
When markets rise, commentators find a way of rationalising the gains. Take the tech bull market. We were told that the 'valuation clocks' were broken and that companies deserved to trade on a higher price-earnings ratio.
We were also told that US productivity had risen and that the US would experience a higher growth rate in the past. We were also told that Greenspan et al would prevent another cyclical downturn. All these comments were spurious rationalisations of an 'irrationally exuberant' market.
4. Buy low, sell high
This advice seems obvious, but investors always ignore it. The demand curve for investment assets is like that for a luxury good -- the higher the price, the greater the demand.
Hence we see turnover rising during a bull market and falling during a bear market. Investors should always be prepared to act contrary to the market.
5. When the rest of the world is mad, we must imitate them in some measure
This observation came from the mouth of an eighteenth-century banker, John Martin, during the South Sea Bubble of 1720. It is another expression of the 'greater fool' theory, namely that you can buy over-priced shares and sell them on at a profit to some sucker.
This speculative attitude has been much in evidence in recent years in the form of momentum investing. Of course, you can make money if you find a greater fool, but you also will lose your money if you don't.
6. During a bull market nobody needs a broker. During a bear market nobody wants one
This is another Wall Street saying, cited more recently by Alan Abelson in Barron's. We are now more aware than ever that most brokerage research is generally of a low quality and that broker recommendations cannot be followed profitably.
Investors should avoid reading research by brokers whose parent company provides financial services for the company concerned.
7. Every man his own broker
This is, in fact, the title of the first investment book, written by Thomas Mortimer in the 1750s. It was republished several times. If you can't trust brokers, you must replace them. The problem is that the private investor is not well-equipped to do so. So, first learn, then invest.
8. Markets can remain irrational longer than you can remain solvent
This saying comes from John Maynard Keynes, the great English economist. He was also an acute observer of markets and a speculator. The point of Keynes's comment is that your observation may be fundamentally correct but it can take the market a long time to catch up.
For example, the dotcom bubble ran for almost five years from the flotation of Netscape in the summer of 1995 to the Nasdaq collapse in March 2000. Many people lost a lot of money shorting the likes of eToys and Amazon.com before the market woke up to its absurd overvaluation of the sector.
9. A mine is a hole in the ground with a liar standing over it
This saying also comes from Mark Twain. It should remind investors to be wary of all projectors, whether they are promoting gold mines, biotech or some other new-fangled technology.
In general, the promise of outsize profits are followed by the reality of painful losses. You will make more money in the long run by restraining your greed.
10. Be diffident when others exalt, and with a secret joy buy when others think it in their interests to sell
This advice comes from the English writer, Sir Richard Steele, in an article for The Spectator in the early 1700s. To my knowledge it is the first expression of a contrarian investment philosophy.
The art of investment lies in judiciously going against the crowd. It is both intellectually more fulfilling to refute the market consensus and in the long run should be more profitable. Academic research suggests that unloved 'value shares' tend to outperform so-called 'growth stocks' over the long run.
Source
Learning the important lessons that history of investment offers, will rev up your investing profits. . .
1. Put all your eggs in one basket and watch that basket!
This saying comes from Mark Twain, but has been applied to stock market investment more or less verbatim by both John Maynard Keynes and Warren Buffett. Modern portfolio theory suggests that one can reduce risk by diversification.
However, if you were an active investor you would do better to concentrate your shareholdings in a limited number of companies which you feel you understand. This can actually reduce risk.
2. When the ducks quack, feed them
This is an old Wall Street adage relating to initial public offerings. Investment bankers are out to make money and will sell the public anything within the bounds of the law.
Research suggests that, in general, IPOs rocket upwards on the first day's trading but tend to under perform comparable companies over a three-year period. Since small investors don't receive fair allocations of the best IPOs but are landed with the duds, they should avoid the new issue market entirely.
3. Markets make opinions, not the other way round
When markets rise, commentators find a way of rationalising the gains. Take the tech bull market. We were told that the 'valuation clocks' were broken and that companies deserved to trade on a higher price-earnings ratio.
We were also told that US productivity had risen and that the US would experience a higher growth rate in the past. We were also told that Greenspan et al would prevent another cyclical downturn. All these comments were spurious rationalisations of an 'irrationally exuberant' market.
4. Buy low, sell high
This advice seems obvious, but investors always ignore it. The demand curve for investment assets is like that for a luxury good -- the higher the price, the greater the demand.
Hence we see turnover rising during a bull market and falling during a bear market. Investors should always be prepared to act contrary to the market.
5. When the rest of the world is mad, we must imitate them in some measure
This observation came from the mouth of an eighteenth-century banker, John Martin, during the South Sea Bubble of 1720. It is another expression of the 'greater fool' theory, namely that you can buy over-priced shares and sell them on at a profit to some sucker.
This speculative attitude has been much in evidence in recent years in the form of momentum investing. Of course, you can make money if you find a greater fool, but you also will lose your money if you don't.
6. During a bull market nobody needs a broker. During a bear market nobody wants one
This is another Wall Street saying, cited more recently by Alan Abelson in Barron's. We are now more aware than ever that most brokerage research is generally of a low quality and that broker recommendations cannot be followed profitably.
Investors should avoid reading research by brokers whose parent company provides financial services for the company concerned.
7. Every man his own broker
This is, in fact, the title of the first investment book, written by Thomas Mortimer in the 1750s. It was republished several times. If you can't trust brokers, you must replace them. The problem is that the private investor is not well-equipped to do so. So, first learn, then invest.
8. Markets can remain irrational longer than you can remain solvent
This saying comes from John Maynard Keynes, the great English economist. He was also an acute observer of markets and a speculator. The point of Keynes's comment is that your observation may be fundamentally correct but it can take the market a long time to catch up.
For example, the dotcom bubble ran for almost five years from the flotation of Netscape in the summer of 1995 to the Nasdaq collapse in March 2000. Many people lost a lot of money shorting the likes of eToys and Amazon.com before the market woke up to its absurd overvaluation of the sector.
9. A mine is a hole in the ground with a liar standing over it
This saying also comes from Mark Twain. It should remind investors to be wary of all projectors, whether they are promoting gold mines, biotech or some other new-fangled technology.
In general, the promise of outsize profits are followed by the reality of painful losses. You will make more money in the long run by restraining your greed.
10. Be diffident when others exalt, and with a secret joy buy when others think it in their interests to sell
This advice comes from the English writer, Sir Richard Steele, in an article for The Spectator in the early 1700s. To my knowledge it is the first expression of a contrarian investment philosophy.
The art of investment lies in judiciously going against the crowd. It is both intellectually more fulfilling to refute the market consensus and in the long run should be more profitable. Academic research suggests that unloved 'value shares' tend to outperform so-called 'growth stocks' over the long run.
Source
Thursday, November 20, 2008
10 truths of getting rich through stocks
You will truly profit from investing only when you have a clear appreciation of its principles and realities.
Once you understand these, you will be better able to keep a cool mind during the inevitable ups and downs -- and reap riches by investing with controlled risks.
1. Investment rewards can only be increased by the assumption of greater risk
This fundamental law of finance is supported by centuries of historical data. US stocks have provided a compounded rate of return of 11 per cent per year since 1926, but this return came only at substantial risk to investors: total returns were negative in three out of ten years. Higher risk is the price one pays for more generous returns.
2. Your actual risk in stock and bond investing depends on the length of time you hold your investment
Holders of a diversified stock portfolio in the US, from 1950 to 2000, were treated to a range of annual total returns, which varied from +52% to -26%. There was no dependability of earning an adequate return in any single year. But if you held your portfolio for 25 years in the same period, your overall return would have been close to 11% -- whichever 25 years you were invested.
In other words, by holding stocks for relatively long periods of time, you can be reasonably sure of earning the generous rates of return available from common stocks.
3. Decide how much risk you are willing to take to get high returns
JP Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. Morgan advised him to 'sell down to his sleeping point'. He wasn't kidding.
Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. Your tolerance for risk informs the types of investment -- stocks, bonds, money-market accounts, property -- that you make. So what's your sleeping point?
4. Dollar-cost averaging can reduce the risk of investing in stocks and bonds
Dollar-cost averaging simply means investing the same fixed amount of money in, for example, the shares of a mutual fund at regular intervals -- say, every month or quarter -- over a long period.
It can reduce (but not avoid) the risks of equity investment by ensuring that the entire portfolio of stocks will not be purchased at temporarily inflated prices.
5. Stock prices are anchored to 'fundamentals' but the anchor is easily pulled up and then dropped in another place
The most important fundamental influence on prices is the level and duration of the future growth of corporate earnings and dividends. But earnings growth is not easily estimated, even by market professionals.
In times of optimism, it is easy to convince yourself that your favorite company will enjoy substantial and persistent growth over an extended period. In times of pessimism, many security analysts will not project any growth that is not 'visible' and hence will estimate only modest growth rates for the corporations they follow.
Given that expected growth rates and the price the market is willing to pay for growth can both change rapidly on the basis of market psychology, the concept of a firm intrinsic value for shares must be an elusive will-o-the-wisp.
6. If you buy stocks directly, confine your purchases to companies that appear able to sustain above-average earnings growth for at least five years and which can be bought at reasonable price-earnings multiples
As difficult as it may be, picking stocks whose earnings grow is the name of the game. Consistent growth not only increases the earnings and dividends of the company but may also increase the multiple (P/E) that the market is willing to pay for those earnings.
The purchaser of a stock whose earnings begin to grow rapidly has a potential double benefit: both the earnings and the multiple may increase.
7. Never pay more for a stock than can reasonably be justified by a firm foundation of value
Although I am convinced that you can never judge the exact intrinsic value of a stock, I do feel that you can roughly gauge when a stock seems to be reasonably priced. The market price earnings multiple (P/E) is a good place to start: you should buy stocks selling at multiples in line with, or not very much above, this ratio.
Note that, although similar, this is not simply another endorsement of the 'buy low P/E stocks' strategy. Under my rule it is perfectly alright to buy a stock with a P/E multiple slightly above the market average -- as long as the company's growth prospects are substantially above average.
8. Buy stocks with the kinds of stories of anticipated growth on which investors can build castle in the air
Stocks are like people -- some have more attractive personalities than others, and the improvement in a stock's P/E multiple may be smaller and slower to be realized if its story never catches on. The key to success is being where other investors will be, several months before they get there. Ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd.
9. Trade as little as possible
Frequent switching between stocks accomplishes nothing but subsidizing your broker and increasing your tax burden when you do realize gains. My own philosophy leads me to minimize trading as much as possible. I am merciless with the losers, however.
With few exceptions, I sell before the end of each calendar year any stocks on which I have a loss. The reason for this is that losses are deductible (up to certain amounts) for tax purposes, or can offset gains you may already have taken. Thus, taking losses can actually reduce the amount of loss by lowering your tax bill.
10. Give serious thought to index funds
Most investors will be better off buying index funds (funds that buy and hold all the stocks in a broad stock market index) rather than buying individual stocks.
Index funds provide broad diversification, low expenses and are tax efficient. Index funds regularly beat two-thirds of the actively managed funds with which they compete.
Once you understand these, you will be better able to keep a cool mind during the inevitable ups and downs -- and reap riches by investing with controlled risks.
1. Investment rewards can only be increased by the assumption of greater risk
This fundamental law of finance is supported by centuries of historical data. US stocks have provided a compounded rate of return of 11 per cent per year since 1926, but this return came only at substantial risk to investors: total returns were negative in three out of ten years. Higher risk is the price one pays for more generous returns.
2. Your actual risk in stock and bond investing depends on the length of time you hold your investment
Holders of a diversified stock portfolio in the US, from 1950 to 2000, were treated to a range of annual total returns, which varied from +52% to -26%. There was no dependability of earning an adequate return in any single year. But if you held your portfolio for 25 years in the same period, your overall return would have been close to 11% -- whichever 25 years you were invested.
In other words, by holding stocks for relatively long periods of time, you can be reasonably sure of earning the generous rates of return available from common stocks.
3. Decide how much risk you are willing to take to get high returns
JP Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. Morgan advised him to 'sell down to his sleeping point'. He wasn't kidding.
Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. Your tolerance for risk informs the types of investment -- stocks, bonds, money-market accounts, property -- that you make. So what's your sleeping point?
4. Dollar-cost averaging can reduce the risk of investing in stocks and bonds
Dollar-cost averaging simply means investing the same fixed amount of money in, for example, the shares of a mutual fund at regular intervals -- say, every month or quarter -- over a long period.
It can reduce (but not avoid) the risks of equity investment by ensuring that the entire portfolio of stocks will not be purchased at temporarily inflated prices.
5. Stock prices are anchored to 'fundamentals' but the anchor is easily pulled up and then dropped in another place
The most important fundamental influence on prices is the level and duration of the future growth of corporate earnings and dividends. But earnings growth is not easily estimated, even by market professionals.
In times of optimism, it is easy to convince yourself that your favorite company will enjoy substantial and persistent growth over an extended period. In times of pessimism, many security analysts will not project any growth that is not 'visible' and hence will estimate only modest growth rates for the corporations they follow.
Given that expected growth rates and the price the market is willing to pay for growth can both change rapidly on the basis of market psychology, the concept of a firm intrinsic value for shares must be an elusive will-o-the-wisp.
6. If you buy stocks directly, confine your purchases to companies that appear able to sustain above-average earnings growth for at least five years and which can be bought at reasonable price-earnings multiples
As difficult as it may be, picking stocks whose earnings grow is the name of the game. Consistent growth not only increases the earnings and dividends of the company but may also increase the multiple (P/E) that the market is willing to pay for those earnings.
The purchaser of a stock whose earnings begin to grow rapidly has a potential double benefit: both the earnings and the multiple may increase.
7. Never pay more for a stock than can reasonably be justified by a firm foundation of value
Although I am convinced that you can never judge the exact intrinsic value of a stock, I do feel that you can roughly gauge when a stock seems to be reasonably priced. The market price earnings multiple (P/E) is a good place to start: you should buy stocks selling at multiples in line with, or not very much above, this ratio.
Note that, although similar, this is not simply another endorsement of the 'buy low P/E stocks' strategy. Under my rule it is perfectly alright to buy a stock with a P/E multiple slightly above the market average -- as long as the company's growth prospects are substantially above average.
8. Buy stocks with the kinds of stories of anticipated growth on which investors can build castle in the air
Stocks are like people -- some have more attractive personalities than others, and the improvement in a stock's P/E multiple may be smaller and slower to be realized if its story never catches on. The key to success is being where other investors will be, several months before they get there. Ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd.
9. Trade as little as possible
Frequent switching between stocks accomplishes nothing but subsidizing your broker and increasing your tax burden when you do realize gains. My own philosophy leads me to minimize trading as much as possible. I am merciless with the losers, however.
With few exceptions, I sell before the end of each calendar year any stocks on which I have a loss. The reason for this is that losses are deductible (up to certain amounts) for tax purposes, or can offset gains you may already have taken. Thus, taking losses can actually reduce the amount of loss by lowering your tax bill.
10. Give serious thought to index funds
Most investors will be better off buying index funds (funds that buy and hold all the stocks in a broad stock market index) rather than buying individual stocks.
Index funds provide broad diversification, low expenses and are tax efficient. Index funds regularly beat two-thirds of the actively managed funds with which they compete.
Thursday, October 23, 2008
How to make tax gains on stock market losses
Stock markets have tanked big time, spreading widespread, contagious panic, pain and gloom the world over.
For equity investors, the pain is, of course, real though not unusual given that share prices routinely go through bullish and bearish cycles.
An array of preferential tax treatment on equity investment offers some balm to investors bloodied by capital losses.
Tax gains on capital losses
Your investments may not always result in capital gains. A loss from the sale of a long-term capital asset (such as investment in equity or equity mutual funds held for more than 12 months) can only be set-off against long-term capital gains.
On the other hand, a loss from short term capital asset is allowed to be set-off against both short term and long-term capital gains.
For equity investors, the pain is, of course, real though not unusual given that share prices routinely go through bullish and bearish cycles.
An array of preferential tax treatment on equity investment offers some balm to investors bloodied by capital losses.
Tax gains on capital losses
Your investments may not always result in capital gains. A loss from the sale of a long-term capital asset (such as investment in equity or equity mutual funds held for more than 12 months) can only be set-off against long-term capital gains.
On the other hand, a loss from short term capital asset is allowed to be set-off against both short term and long-term capital gains.
How to set-off capital losses
Accordingly, to obtain the maximum benefit one may use the following order of priority to set-off capital losses:
First, try setting off against short term capital gains not subjected to securities transaction tax (STT); this will save 30 per cent tax (since slab rates are attracted);
Second, try setting off against long term capital gains not subjected to STT and thus save 20% tax.
Last, try setting off against short-term capital gain subjected to securities transaction tax.
Where capital loss cannot be set-off and tax mitigated during the ongoing financial year, it can be carried forward to the next year provided you file a loss return along with your return of income. In fact, you can carry forward such losses for up to eight years.
Accordingly, to obtain the maximum benefit one may use the following order of priority to set-off capital losses:
First, try setting off against short term capital gains not subjected to securities transaction tax (STT); this will save 30 per cent tax (since slab rates are attracted);
Second, try setting off against long term capital gains not subjected to STT and thus save 20% tax.
Last, try setting off against short-term capital gain subjected to securities transaction tax.
Where capital loss cannot be set-off and tax mitigated during the ongoing financial year, it can be carried forward to the next year provided you file a loss return along with your return of income. In fact, you can carry forward such losses for up to eight years.
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