How to avoid destruction of wealth and lock in your stock market gains

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Reliance Power, Unitech and Reliance Capital (2008). You will note that these are often very popular stocks that rally purely based on narrative. Their valuations are completely out of whack with reality, and yet, money continues to chase such stocks.

And then of course, they completely destroy shareholder wealth. Look out for these characteristics in stocks you own and dodge potentially massive destruction of wealth. This first step is perhaps also the most difficult to execute.

In a rising market, such narrative driven stocks gain the most with the FOMO (fear of missing out) factor kicking in hard. You don’t want to sell out and miss out on ‘potentially’ large gains that are “just around the corner". Perhaps, one way of working through this is to ask yourself – Is it better to lose 20% upside, or avoid an 80% downside? Second, the time to take more risk for more return is perhaps over.

Such investments are made in times when few are excited about the prospects of high returns from stocks. Today, everyone is excited about earning super high returns, and this has driven up stock prices to levels that have conversely limited the potential for future returns. How do you counter this? Well, you take some risk off the table.

You do this by moving money from the ‘high risk’ bucket to the old, boring, and far cheaper large cap blue-chip stocks (the “low risk" bucket). When I say high risk, I am generally referring to investments where valuations are factoring in irrational expectations. This is where the chance of taking a big hit is the highest.