Despite the risks and challenges inherent to stock market investing, lot of people have made good money from stocks. Some thoughts and tips on stock market investing are given below. These have to be seen as broad guidance and should be calibrated to suit different conditions.
- Making money from stocks is actually quite simple if one were to consider the revenue model. Buy a stock A at X and sell at Y. Return, quite simply, is Y - X. If Y > X, one makes profit, it’s as simple as that. The thing which is not simple, however, is how to make sure one picks stock at price X so that the likelihood of it going on the upside is almost certain and the likelihood of it going downside is almost nil. This should surely be the case in the medium-term and long-term.
- Choose a certain amount of money, say X, which represents the money per share that one is willing to and can afford to loose on a stock. Don’t buy any stock which has a sticker price above 1%-2% below X. With brokerage, taxes, etc. the final price per share will come close to X. The exact numbers have to calibrated based on the brokerage, taxes, etc. prevalent in the stock market one chooses to operate in. The idea is to cap your loss per share to a maximum of X. Remember a bad news about any stock can lead its market price to drop closer to zero (like in the case of Enron the stock price fell to few cents from 90 to 100 dollars in a few days time)
- Stocks that are picked should be bought in sufficient quantity. Imagine one bought 100 shares of a company at X. So the total investment was 100 X. Assume the stock price goes up by 60% (which means stock price would become 1.6 X). In such a case the investment will grow to 160 X, a profit of mere 60 X which is not much. In fact the real return will be lesser than 60 X. If however, 1000 shares were bought the profit will be 600 X.
- Build position of an amount around A to B in the selected stock, where A to B would have to be significantly large enough. This at the per price cap of X (from point 2 above) would translate to around M to N stocks (which should be large enough so that overall profit is high enough as per point 3 above) . For stocks with lesser price the quantity will be much larger.
- The idea behind taking a sufficiently large position in any stock is that the increase in the price per stock will translate into gains that are significant enough in volume terms in case they are significant in percentage terms. Obviously, this would mean losses will also be significant enough in volumes terms in case stock price declines significantly in percentage terms. And that is what it should be as this is precisely what the game of stock picking is essentially all about.
- Assume one buys one stock by investing an amount X. On the downside, one can loose the entire X, which is the maximum risk per share. However, on the upside, X can become 1..5 X, 2 X, 5 X, 10 X or even higher (a multi-bagger as Peter Lynch would call them). The science and art here is to buy the stock at a price at which the probability of it going further down is minimized which in turn would minimize the risk of loss. If this can be coupled with the analysis of the company fundamentals behind the stock that the probability of the stock going up, if not immediately and in the short-term but certainly in the medium-term and long-term is reasonably high enough it would maximize the de-risking of eventual gain.
- Price of a stock prices move up and down based on news related to the overall economy, industry sector and the specific company behind that stock. Experts in the market distill the news to figure out the direction and quantum of price movement. This change in price can move in the direction to the extent of the quantum thought to be the “needed correction”, over several days, weeks and even months.
- Expectations around the financial performance of the company play a major role in reinforcing the impact of relevant news and in some way are seen as the culmination of the news that keeps trickling in. The actual results on its own as also compared with the expected results reinforce or counteract the direction and quantum of price movement.
- It is commonly understood that if the price of a stock declines by 50% then it needs to rise by 100% to be back where it was at the start. For example, if the price at which a stock is purchased is X and subsequently falls by 50% to reach 0.5 X then to be X again it needs to rise by 100%. This however is due to mathematical base effect, percentage increase for the same quantum of increase declines with the number becoming larger and vice versa. This is not so relevant since theoretically speaking, on the down side stock price can never go below zero but on the upside can reach infinity. It is an interesting thought to consider that if a stock picker is lucky enough in his life to invest a substantial capital in one stock that goes up infinite times, figuratively speaking, he will be infinitely rich, again figuratively speaking
- Suppose a person has 2 Z amount and he invests Z in stock A and another Z in stock B. Assume company behind stock A shuts shop making Z(A)=0, also assume company behind stock B does stupendously well so that Z(B) becomes N X, where N is a sufficiently high number. For an extremely high value of N, the person would have made it in life, at least the financial part of it.
- Trading should be avoided to the extent possible. Assume a person buys a stock at price X and sells it at a price Y. Return from such an investment will be Y - X. However, real return will be much lesser due to brokerage, taxes, etc. Let’s assume this cost is a% of the base cost. So the actual buy price will be X + aX and the actual sell price will be Y - aY. The real return in this case then would (Y + aY) - (X + aX), which is equal to (Y - X) + a(Y - X). As is clear, a(Y - X) is what goes to the broker and the Government. The number ‘a’ can be assumed to 1% to 2% in case one holds the stocks for the returns from it to be considered under long term capital gains. The number ‘a’ would be much higher in case the return falls under short term capital gains.
- Patience to buy or not to buy is very important.In addition, maintaining liquidity is quite important. Having liquidity when opportunity to buy a stock presents itself is so utmost important that it can make a significant difference to the overall portfolio performance. Hence having patience to invest money in a staggered manner is crucial as it allows at least some part of the portfolio getting picked up at the bottom or very near to the bottom. The cheaper one can buy the better off one is. In any case, one should maintain 10% of portfolio as “contingency” amount to be used only when any rarest of rare opportunity presents itself. This by definition would happen but once or at best few times in a stock picker’s lifetime. Patience to sell or not to sell is equally important in a likewise manner.
- Big players have the leverage to cause huge gains and losses over a short period of time, in fact at times within few minutes, hours or one trading day. These big players buy and sell in huge numbers leading to sudden and extreme price changes.
- Select M to N stocks across various sectors. M to N could be 20 to 25 stocks or any number of stocks that can be comfortably managed and depends on how much time one can spend on managing the overall portfolio (Walter Schloss apparently had more than 100 stocks whereas Warren Buffet apparently has fewer number of stocks) . Buy them at the right time, which means at reasonably low price with immense upside potential in the future. Buy in sufficient quantity so that possibility of significant gain is large.
- Read the last two years annual report and don’t invest outside the index. Companies which are in the index are under higher scrutiny from auditors, analysts and authorities. However, they all could go wrong and mislead an investor (think Enron). That is why the cap of X is helpful in case there is a fraud. History tells us this is likely to happen again.
- Buy dividend paying stocks if one wants some tax-free income to come one's way. Dividend are tax free and can be re-invested in the same stock to effectively reduce the price per stock.
- Buy with the thought of holding forever (Warren Buffet style). However, assess the portfolio performance regularly (every day if possible otherwise at least once every week) and if there is a case to sell, don't hesitate to sell.
- Target how much money you want to have so that you can live comfortably. First and foremost try reaching that target. Once one is financially secure, one can make riskier investments that have the potential to earn more. Keep some part of the money in bonds or fixed deposits always. Don't be 100% invested in stocks.
- Avoid mutual funds, unit-linked plans and exchange traded funds, if one can invest in stocks directly. These are designed to generate consistent salary and commission for the fund mangers even if they make loss for the investors. They clearly violate the principle of pay for performance.
- If one has stayed invested in life insurance policies, mutual funds, unit-linked plans and exchange traded funds for several years, one may want to continue. If one wants to exit, it is advised to compute the surrender cost, consider the returns so far and take an informed decision. Don't exit just because experts tell you they are not good or someone tells you the best investment is putting your entire money in stock market.
