1. Over-leveraging
Buying stocks with borrowed money is leveraging. And it is a crime that many investors committed last year.
Typically, a broker either lends or allows the investor to have a larger position than the money that has been deposited. The interest rate on such lending is higher. Consider this, often an investor has Rs 1 lakh and has positions in the market four to five times of that.
When things are good and stock prices are rising to dizzying levels, everyone is happy. The return on investment outstrips the interest cost. But when the market falls, it is a complete disaster.
For instance, when Reliance Industries was trading at Rs 2,500, you bought stocks worth Rs 4 lakh (Rs 400,000) on an initial capital of Rs 1 lakh (Rs 100,000). If the stock moves to Rs 2,700, it has gone up by only 8 per cent, but the return on investment (Rs 1 lakh) is 32 per cent.
Now if the stock dips to Rs 2,000, down 20 per cent, you stand to lose 80 per cent. Now if you add the interest cost to the total capital loss, then the initial capital might have been wiped out.
Lesson: Multiplier effect has both sides. Use the loan facility very responsibly and with stringent limits to it.
Image: A man walks past a screen showing Prime Minister Manmohan Singh outside the Bombay Stock Exchange building in Mumbai. | Photograph: REUTERS/Prashanth Vishwanathan
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