Stock investing has been an evergreen and popular investment and retirement planning vehicle for investors. It is, however, fraught with dangers unlike bank fixed deposit, bond or even gold. Here are ten steps that will allow you to minimise the chances of costly mistakes while playing in the stock market:
1. Start small. In the stock market it is always best to begin your investment in small instalments. This way, the cost of wrong investment decisions will not hurt your financial position or monthly household budget. If you succeed initially in making the right bet, it doesn’t mean you should invest all your money in the market. You should only invest the amount in stocks that you will not need over the next two years.
2. The 20 percent rule: As a thumb rule first calculate your monthly savings after paying all the necessary expenses besides maintaining some liquidity in your savings account. In the first six-months, don’t invest more than 20 percent of your investible surplus. Raise this amount as you gain confidence and get hold of the market rhythm and momentum.
3. Focus on building a portfolio: Equity is a volatile asset and prices can move widely in both directions in the short-term. As an investor you need to protect yourself against these wild swings. One of the best ways to do it is to build a portfolio of 10-15 stocks rather than 2 or 3 stocks that may be popular. At any point in time some will do well while others languish. A portfolio will help you smoothen the volatility in individual stocks.
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4. Don’t bother too much about picking a multi-bagger: Finding multi-bagger stocks is often a matter of luck or being at the right place at the right time. Searching or asking for tips for a potential multi-bagger can lead you to value-traps and you could end-up losing your capital in the worst case scenario. An investor with the wrong portfolio will fail to make money in the best of the markets while one with the right stocks in her portfolio will make money even in a dull market.
5. Common companies make the best portfolios. Start with companies and products that you are familiar with. Start buying stocks of the companies whose products and services you use and are popular. The safest way is to start with industry leaders. Market leaders most often have the best finances in their industry and their stocks prices fall the least during recession and are one of the first to rally when growth resumes in the industry. However, this doesn’t mean that you should buy the stock of every industry that you know. Be a little choosy or the entire process may overwhelm you.
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6. Stick to sectors and industries that you understand. The Indian equity market is very diversified, with thousands of stocks across dozens of industries. You don’t need to capture the entire universe in your portfolio. Stay with companies and sectors that you understand and where information is easily available. For example, if you have a fair understanding of the operations of say the automotive industry either because of your training or your friends, buy stocks in that sector. With the passage of time, your horizon will widen and you can invest in more sectors.
7. Sectors and companies go through cycles: You should note that markets go through cycles or what analysts call sector rotations. Every few months sectors or the stocks that drive the market changes based on factors such as the global economy, changes in interest rates, government policy, currency movement or overvaluation or under valuation in specific stocks. This means that you should keep booking profits at regular intervals and churn your portfolios at regular intervals.
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8. Have patience: You should be patient if a particular stock doesn’t do well immediately after you bought it. If its fundamentals are good and management is credible than sooner or later, it will do well. Similarly, don’t hesitate to book profits in stocks that have run-up too soon or too fast. As a thumb rule, if a stock in your portfolio doubles in value, sell 50 percent of your holding and recover your capital. You can invest the money in new stocks.
9. Don’t overdo diversification: There is cost to diversification in terms of time and effort, that’s why you should not add too many stocks in your portfolio. Your portfolio should have as many stocks as you can track and research actively based on the time and resources available with you. For a typical retail investor with Rs 10 lakh worth of investment, 10-12 stocks are more than enough. If you are too ambitious you can stretch it to 20 but don’t go beyond that. Remember the 80:20 rule. At any given time 80 per cent of the return in any portfolio comes from 20 percent of the stocks.
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10. Learn some basic stock valuation matrices: The two most common variables to value stocks are price to earnings multiple also called P/E multiple and price-to-book or P/B ratio. P/E multiple is calculated by dividing a company’s latest market capitalisation (or share price) by its reported profit after tax (or earnings per share) during the latest financial year or the last four quarters. A company with lower P/E multiple is considered to be undervalued and vice-versa.
Price-to-book is calculated by dividing a company’s share price by its book value or net worth per share in the latest financial year. A stock with low P/B ratio can indicate an undervalued stock. P/B ratio is usually used to value stocks in capital intensive and asset heavy sectors with volatile earnings such as banks, non-bank finance companies, insurers, metal, mining & oil & gas companies. In contrast P/E ratios are mostly used to value asset light businesses such as technology, FMCG and consumer goods manufacturing.
Use valuation ratio to compare two stocks in the same sectors and not across sectors. For example, FMCG stocks always get higher P/E than say steel or cement companies. So a lower P/E for a cement company doesn’t make it cheaper compared to say an FMCG company.
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).
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