Success in stock investing means ‘Earning returns well above the FD without the risk of losing capital’
To invest in stocks successfully, you need to know:
- How to choose/pick good stocks to invest in?
- What is the right price of stock?
- How much of each stock should you own?
You need to follow the three rules given below that answer these three essential questions:
- Invest in stocks of great businesses, and hold them for a long time.
- Invest at attractively low prices, i.e. the right prices.
- Manage a diversified portfolio (of not more than 20 such stocks).
1. How to choose/pick good stocks to invest in?
Buying a stock is very different from investing in a company’s stock. Buying a stock in the expectation that it will grow in value for years and therefore holding it for a long time is investment. Everything else is speculation. Great businesses grow and become more valuable with time because they have a robust, profitable and growing business. Holding their stocks for a long time allows the power of compounding to work its magic and give you great returns.
The future of mediocre and poor businesses is at best uncertain. When you buy their stock, you are actually hoping that there will be other buyers who will be willing to pay higher prices for it! Ask yourself, ‘Why would they buy it at higher prices? Are you banking on their ignorance or stupidity?’ Because if you are, then remember that the guys who sold you that stock have already done so successfully! Never buy stock of a mediocre or poor business, no matter how cheap its price may be.
What about companies that are not great businesses but are better than mediocre? These companies may see a modest growth in value over time, and to earn good risk-adjusted returns, you need to buy them only when they are available at a hefty discount. And whenever required, you should sell to make way for the best. Read our blog post How to choose/pick good stocks to invest in? to know more.
2. Why wait for the right price, i.e. an attractively low price, before buying a good stock?
The second rule, ‘Buy at attractively low prices, i.e. the right price’, needs some explanation. Imagine that you knew the Fair Price of a stock, which is determined from its fundamental ability to generate profits. You would then be able to assess whether the current prices are attractive/right or not. Buying even great businesses at high prices can result in poor returns that are perhaps lower than even a Fixed Deposit’s (FD’s) returns over the next 3-5 years. And if the markets were to correct in this period or if the company were to suffer a short-term setback, the usual outcome would be sharp corrections. You would then be staring at a loss in your portfolio, shaking your confidence in an otherwise strong company.
Remember that sooner or later the market gives you many opportunities to buy such wonderful businesses at attractive prices. (The proof: Look at the 52-week Highs and Lows of any of the SENSEX stocks.) An attractively low price is the safety that good investors demand even when buying a good/great stock! This protects against some, if not most, of the volatility that can happen in the stock or in the market. Waiting for the right price of good stocks requires patience and often the courage of conviction to take decisions differently than the market. Why? Because as explained earlier, in the short term the market behaves like a voting machine (prices move depending on what people favour) and may over-react to short-term events, offering the stocks that you would love to own at an attractively low price. Read our blog post on how to find What is the right price of stock? to know more.
3. How much of a right stock should you buy?
The rule of thumb ‘Manage a diversified portfolio of not more than 20 great/good stocks’ says it all, but requires some explanation. Firstly, it says that you need to build a diversified portfolio and not over-expose yourself to a stock or a sector, because that increases your risk. Growing your money requires deploying your entire Investable Surplus to earn high risk-adjusted returns. For this, you have to get things right overall, and not just on a couple of stocks. A diversified portfolio reduces risk and enables you to absorb the downside that can affect a few stocks or a sector. The latter is very critical to success in investing, at times even more important than having done great research. However, do note that having more than 20 stocks is too much of a good thing. It may lead to over-diversification in a Direct Stock portfolio: i.e. the risk would not be reduced any further, but the returns would be adversely impacted.
Now, you know the three guiding rules that together form a sound framework for investing in stocks successfully. And you can see that it’s quite simple. However, success will follow only when you stick to the rules consistently. The common thread binding great investors like Benjamin Graham and Warren Buffett is that they followed a simple and sound framework of investing and stuck to it with discipline.
Read the next article to know ‘How to choose good stocks to invest in’
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