If there was a simple answer to how one could earn returns that are higher than the inflation rate, everyone would have flocked to it.
FDs, when done in the safest banks, give interest rates that are almost the same as inflation rates. The reason one earns higher-than-FD returns is that there is a higher risk.
Therefore, in investing, risk cannot be avoided but has to be managed. From amongst the choices available to retail investors, equity is the preferred asset class.
Let’s take a look at what the concept of equity means.
What is equity?
Simply put, equity refers to a shareholder’s stake in a certain company or business.
What is an equity fund?
An equity fund or a stock fund is a type of mutual fund that primarily invests in stocks.
Types of equity investments
There are two ways one can invest in equities – Direct Stocks and Equity Mutual funds. Direct Stock entails buying stocks of select companies directly through your broker. There are also different equity mutual funds you can invest in.
Types of Equity Mutual Fund:
ELSS Funds– These are tax saving funds that invest in the stocks across market capitalization. They offer a tax deduction, in addition to capital appreciation.
Sector Funds – Invest in stocks from a specific sector. E.g. Healthcare Fund will only invest in Healthcare/Pharma stocks.
Global Funds– These mutual funds invest in stocks across the globe rather than restricting their investments to a single country.
For details, click on ‘Types of mutual funds’
What are the popular investment strategies?
The ‘Sahi Way of Investing in Equity’ takes into account the investor’s knowledge and experience in investing and the size of the portfolio.
However, any good process for investing in equities must ensure that they stay invested and let compounding do its magic.
This requires investors to understand and have confidence in the investment recommendations and decisions.
So a good process must have a sound rationale that is easy to understand.
Are there any rules every investor must follow?
Yes; stay invested for long and let compounding grow your money.
So the do’s and don’ts can be stated simply as:
do everything to stay invested and don’t do anything that will make you stop investing in equities.
Can one get rich following this advice?
Yes, absolutely! Savings grow into wealth when you put your surplus money to earn returns higher than inflation and let it compound for a number of years.
As you can see there are 3 variables:
- Surplus (the saving you put to work)
- Returns (CAGR) that you earn
- No of years you stay invested and earn these returns
But, higher returns can create wealth faster!
Retail investors can neither afford this kind of drop in their savings nor do they have the temperament to handle this kind of risk.
So they will not be able to stay invested in a high risk-high return portfolio. Those who claim they can are probably investing a very small fraction of their surplus – the ‘can-lose’ money.
Hence, chasing higher returns comes with a risk of not meeting your wealth creation goal.
Equity Investment Tips for Beginners
Investing in stocks vs investing in mutual funds – What is the right option?
Say you have a stock that falls 20%. You are likely to be upset, very upset if you have put a lot of your savings into it.
However, when you have a 20-stock portfolio, you may see that this stock is only 5% of your portfolio and hence the impact is only 1% on the entire portfolio (or even lesser as some other stock could have gone up). This helps us make level-headed decisions.
Another advantage of thinking portfolio and not individual stock or MF is that you are preventing yourself from getting attached to a stock. This makes it easier to sell when required.
What is a well-constructed portfolio?
A well-constructed portfolio helps manage both risk and returns. It is instrumental in achieving reasonable returns while managing the risk at a level that ensures that you stay invested and reach your financial goals.
Risk is prevalent and exists, but does not always materialize. For example, you use a motorcycle regularly; sometimes you wear a helmet and sometimes you don’t.
Till now you have not had an accident. Does that mean you were over-cautious on the days you wore the helmet and smart when you didn’t?
An accident is unpredictable but taking precautions and wearing a helmet every time you ride a motorcycle prevents serious damage and saves lives.
Are Mutual Funds better than FD?
Beyond the choice of the bank, there is no decision you are required to take.
However, MFs are not the same. They can yield returns much higher than FD, but involve a greater risk factor.
That’s why there is the all-famous warning: they are subjected to market risks.
There are 350+ equity mutual funds that follow different processes/strategies. Selection requires some knowledge and expertise.
A Mutual fund is a portfolio managed by an expert. Then why does an investor need to manage his portfolio?
Mutual funds are products. Fund managers are responsible for managing the product.
However, it is not their responsibility to ascertain whether the product is suitable for you and remain suitable even when market conditions have changed. That’s the job of your Investment Adviser.
An investor needs to know and do what is right for his portfolio. That is where the Investment Adviser comes in.
Investment Adviser is responsible for assessing your return requirement based on your risk appetite. Based on this assessment, a suitable investment solution can be chosen.
Why do the returns of MF vary over time?
Every fund fits in a category. For eg: Large cap fund managers build and manage the portfolio within the rules specified for the large cap category.
Within these rules, every Fund Manager uses a process or a strategy to select stocks that can deliver great returns and the risks which are acceptable to him.
However, no process works in every market conditions and hence, there are periods of good and underperformance.
For eg: small cap funds outperformed the markets in a bull market of 2017 but underperformed in 2018 and 2019.
And how does one manage this uncertainty?
By ensuring your portfolio is diversified. One of the biggest advantages of investing in mutual funds is diversification.
Investing in a fund enables you to invest in multiple stocks – this is one level of diversification. However, this is not adequate.
There is one more dimension of diversification that you need – diversification across investment style/processes/strategies.
The most common ones and the times they work best are:
- Momentum – has worked best in rising markets
- Value/Dividend – in flat or falling markets
- Quality – in tough/bad economic conditions
- Size – in good times.
For a more detailed understanding read How to achieve the right diversification in Mutual Funds?
Disadvantages of Mutual Fund Investments
MF Sahi hai, but that does not mean every MF is Sahi for you. The way in which MF is sold to you may not be right. MF is mostly sold based on past performance.
This is similar to driving by looking into the rearview mirror; it does not work. A fund is a top performer today because the prices of the stocks in its portfolio have already gone up.
This makes it difficult for the fund to deliver returns again in the coming years since the new money is invested at increased prices.
For example: check any small cap fund and you will see great returns in 2017, but the returns in 2018 are negative and many are still negative in 2019.
So, the right advice should have been to sell small cap funds in 2017 when it was still rising.
However, most retail investors were buying small cap funds in early to mid-2017 and they would not have recovered yet and probably it will be a few years more before they do.
The second disadvantage of MF is that you incur a 1 – 1.5% Fund management cost. If you buy a Regular Plan, an additional 0.75% distribution cost will be added.
Thus, MFs come at a cost. This cost hurts when the returns are not well above the FD interest rates.
How to select the right Mutual Fund in India?
There are three important things when short-listing an MF:
1. Quality of the Portfolio:
However, it can backfire in terms of higher drawdowns – bigger losses when the market corrects. This may not be acceptable and hence you need to assess the quality of the fund’s portfolio.
Alternatively, a fund manager may ‘mimic’ the benchmark index, i.e., the portfolio will be very similar to the Index and hence you cannot expect higher than index returns.
2. Consistency of Returns:
As an investor, we are more interested in a fund earning consistent returns that compounds, rather than swings from very high to low/very low.
We also need a way of looking at returns that do not have the limitations of using past returns, which depends a lot on the start and end dates; especially because we could enter and exit at any time.
3. Upside Potential:
Once you have shortlisted a fund, you need to know if it is the right time to buy it – especially if you are investing a lumpsum amount.
For this, you need to know the upside potential of the fund; what is the likely return one can realistically expect.
MoneyWorks4me fund selection methodology is based on this:
What are Index Funds? Should you invest in one?
An Index Fund is a mutual fund where the portfolio of stocks is not actively selected by a fund manager but is a replica of the Index. Eg: the ‘Nifty 50 Index Funds’ portfolio matches that of Nifty 50.
Mutual funds are called actively managed funds while investing in index funds is called Passive Investing.
The advantage of an Index fund is that its portfolio is predictable and comes at a lower cost. So you get the benefit of diversification at a lower cost.
However, the decision to invest in Index funds is similar to any mutual fund.
Investing in stocks vs Mutual Funds: Advantages and disadvantages
The benefits of directly investing in stocks, over a 100% MF portfolio are:
- Higher control of your investment: You can decide what to buy when to buy/sell and how much.
MFs are not the best positioned to take advantages of some opportunities, such as investing at attractive prices in a bear market (usually they face redemption pressures and require to sell rather than buy) or from a short term performance problem in an otherwise good company (because they need to be the best performing fund or close to the top to attract more funds).
A retail investor can do all this. This can add significantly to better returns while risk can be low.
- Lower cost: Investing in direct stocks incurs brokerage cost which is significantly lower than the expense ratio of Mutual Fund.
But isn’t investing in stocks directly risky?
Remember: MFs also invest in stocks.
The biggest risk is ignorance.
So does it make sense to have a portfolio of Direct Stocks and MFs?
Yes! You can think of your direct stocks portfolio as one fund which you can build and manage directly under guidance from your investment advisor.
This enables you to get the best of both:
- Invest in strong investment-worthy companies through a direct stock portfolio on which you have higher control and lower cost.
This is also likely to enhance your returns as you can pick and choose stocks with high upside potential.
- Diversify across processes by investing in a set of MFs. SIP for your monthly savings in a set of MFs. Invest lumpsum in those funds with higher upside potential.
However, not all advisors are equipped to guide you on investing in stocks.
How to ensure you have selected a strong investment-worthy company stock?
The wider the moat, the more difficult it was for enemies to enter and capture the castle. For you, the castle is a company in which you want to invest.
The moat is A sustainable competitive edge, which protects the company from the competition and tough economic conditions!
During tough times, companies fight harder to win customers, thereby leading to a fall in prices and thus, margins.
Only a company with a wide, unbreachable moat – a competitive edge – can maintain and grow its profits even during tough economic conditions.
Is there a way to confirm if a company has a sustainable moat?
Why 10 years? This is because, over a 10-year period, the company is likely to have experienced one full economic cycle – good & bad times; growth and recession.
A business does not do well over a 10–year period just by accident! A company which has performed well over a 10–year period is most likely to have a moat.
But does it mean that the past performance is a guarantee of future performance?
However, an excellent past performance over a long period is an indication of a competent Management that can handle the ups and downs it is likely to face in the future.
For that, you need to have an assessment of what is the future upside potential from the current price to decide whether you should invest in it at that price.
What else is essential to qualify as a great business worth investing in?
In addition to a sustainable moat and its excellent track record, one more thing is essential: A Respectable Management.
What is Upside Potential in Stocks?
There are different ways of making this estimate. MoneyWorks4me makes an assessment of what returns one can expect from the current price should the stock trade at its fair price 3 years later.
It is mentioned as CAGR. This is not to say that 3 years from now, the stock will trade at this fair price.
However, it gives us a good way to decide whether we should invest in it as the current price is attractive or fair or avoid it because it is expensive.
Is there a good thumb rule for making decisions based on Upside Potential?
A few very good stocks could even be in the 6 – 10% range. Stocks with less than 6% upside potential are expensive and should not be bought.
In fact, one should consider selling such stock partly or fully.
How do you arrive at the fair price of a stock?
However, fair value is an estimate based on certain assumptions that every analyst makes.
They then track actual company performance versus their estimates and, over a period of time, come to a judgment of its fair value.
The usefulness of fair value is that it provides a better anchor for taking buying and selling decisions.
This is achieved by extending the idea of fair value to the stock’s Upside Potential. For more details read ‘What is the right price to buy a stock?‘
What is the best way to invest your monthly savings?
This is tougher than one imagines. Committing to a plan that gets automatically executed without your intervention every month is seen to be most effective.
This is what a SIP (Systematic Investment Plan) does. Right now, you can set this up for mutual and index funds.
Looking at the success of SIP in mutual funds, solutions to invest your monthly savings in a portfolio of stocks are also now available.
They may not be as regimented as mutual funds, but those convinced about direct stocks will find it acceptably simple.
Learn more about investing in equities-stocks, mutual and index funds, so that your knowledge keeps pace with your growing portfolio.
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