8 Most Important Principles when Investing in Equity Stocks & Mutual Funds
The last two years have been a roller coaster ride for equity investors all around the world we had the kovitz shocks and subsequent lockdowns the Chinese markets have regulatory interventions the Europeans have the Ukraine-Russia war the Sri Lankan stock exchange has been sporadically closing and with the u.s federal reserve hiking interest rate it sure is making the global financial markets quite jittery so a lot has been happening and for people who are new to investing in equities might also find this very discomforting and so in this post we shall put forth eight principles of equity investing that have stood the test of time and have helped investors make superlative gains these principles have helped me immensely over the years and are equally applicable when investing directly in stocks actively manage mutual funds or index funds.
1. Know what kind of investor you are
like everything in life investing 2 needs a strategy and if you are putting up capital in the equity markets without a plan then it is not likely to be a profitable endeavor now strategies can be of many types in the case of mutual funds it’s about how you allocate your capital across asset classes passive funds versus actively managed funds and how disciplined you are as an investor in the case of stocks, there is a lot more strategy options:
- growth investing
- income investing
- value investing
- trends following
- momentum strategies
- swing investing
- index investing etc
now while I use the word strategy a lot of it is also about the kind of investor you are in fact my own equity investing strategy revolves around keeping it simple so
- firstly I invest in actively managed mutual funds and index funds in a 50-50 ratio which is generally in the large and mid-cap space
- secondly, I research and invest in mid-cap and small-cap stocks of growing companies that are available at reasonable valuations and have wide economic modes
so every rupee I put in is built around these two areas which kind of fits in well with how I operate and how I take risks and how I want my money to grow so remember when investing in equities always have a strategy in place and know what kind of investor you are
2. Expect volatility and profit
Investing in stocks means dealing with volatility notice i use the word volatility and not risk and that’s because these two words are very different yet people think of it as same to put it simply volatility is the up-down movement in the price of a stock or the nav of a mutual fund and risk should be looked at as the chance of having a permanent loss of capital in our view volatility is something that cannot be avoided and for many successful investors it is the volatility in stock prices that presents them with wonderful opportunities to buy low and sell high and consequently make a lot of profits in the process now while volatility is always going to be there in equities there are a few ways of managing it at least on a portfolio basis
- one of the simplest way is to invest via sip or systematic investment plans that inject money into equity markets at regular intervals and therefore help in smoothing out the right
- a second way of controlling volatility is by taking care of your asset allocation which not only requires you to tactically divide your capital across different asset classes like equities gold and bonds but also within equities one would need to look at splits across. large caps mid-caps small caps momentum stocks value stocks international equities etc
3. Control the risk
There’s an old quote that says making money is easily keeping it is difficult and it’s not just the logic even the mathematics supports that for instance if your portfolio were to fall by 30 then a subsequent 30 rise in your portfolio will not be enough and one would still come up nine percent short and which is why building the necessary protections around one’s equity portfolio is a must-do for all investors so what are these protections
- Diversity
number one is always diversity in fact there is a beautiful line that says while concentration builds your wealth diversification protects your wealth but that doesn’t mean one has to go hammer and tongs with diversification in fact just having a proper mix of large mid-small-cap and the international fund should be sufficient and if you’re into stocks then a mix of 15 to 20 stock should give you adequate diversification
- Rebalancing
the second way of protecting your equity portfolio is by rebalancing you see over time some part of your portfolio will get lopsided and that mostly happens due to expensive valuations so just like how a car driver gets his vehicle back on the road it’s the investor’s responsibility to rebalance so that the portfolio reaches accordingly and gets back on track and the third protection strategy one can use is a stop loss which is a sort of a forcing function that instructs your brain to take a hard call for instance when I invest in stocks and although I put in hours of research I still have a mental stop-loss of 30 percent what it means is that if that stock I bought falls by over 30 percent when let’s say the market has fallen by 10 percent then I force myself to assume that I might have made some mistake in my research and I forcibly exit my position in that stock, in other words, it’s my way of saying sorry and having that stop-loss not only protects my portfolio from any further slide but it also allows me to dust off my clothes and move on to the next opportunity
4. Safety margin
A prime difference between investing in a debt instrument like a bond and investing in an equity investment like a share is the number of assumptions one has to make in the case of a bond it comes down to assessing the probability of the bond issuer paying the interest and premium which is mostly a function of the profits made however when we work with equities the number of assumptions is almost unlimited one has to assume the revenue growth of the profit margins industry dynamics market share debt levels competitors past valuation current valuation future valuation and a dozen other variables and that’s where keeping a large margin of safety becomes important so technically a margin of safety can be explained as the investor’s downside risk protection when he or she purchases security at a price which is significantly below its intrinsic value, in other words, a large margin of safety not only protects you from some assumption risks that you might have made in your analysis but it also, improves your chances of earning higher returns while taking a lower level of risk or as i would say to the absolute discomfort of my finance professors lower the risk higher the return
5.IGNORE THE NOISE
investment noise is the constant drum and beat of news information and tips that we are subjected to day in and day out this noise comes to us via newspapers tv channels Twitter youtube Instagram our friends, and even our workplace and as a firm rule one should get into the habit of ignoring this noise to improve one’s odds of investing success now noise can be of three types the
- first is what is called unusable noise which refers to information that is not likely to alter our actions or behavior say for example an earthquake in Madagascar or a political coup in Argentina
- secondly, we have untimely noise which is information you are not likely to use in the near future and the story could have changed dramatically by the time you are ready to use it
- the third noise is hypothetical which is based on what someone thinks will happen as you might have guessed this is the most common type of noise and includes experts who continually talk about the economy or the stock markets the point is tuning out the noise is just a matter of habit and what can come to your rescue is a clear investing strategy
your own experience and the knowledge that one can extract from good books some newsletters
6. Don’t use leverage while Investing in equity
so there are some factions that will disagree with what I’m about to see next lending companies will disagree brokerage companies will challenge my logic traders might call me dumb and that’s because it’s our contention and advice that everyday investors should not use leverage to invest in the stock markets you see investing in equities is a speculative activity and by taking a personal loan or using margin trading or options etc the investor ends up adding an additional layer of speculation on something that already has a fair amount of risk in fact no one can explain this better than warren buffett who had this to say in his 2010 shareholders letter and a quote when leverage works it magnifies your gates your spouse thinks you’re clever and your neighbors get envious but leverage is addictive once having profited from its wonders very few people retreat to more conservative practices and as we all learned in our third grade and some relearned in 2008 any series of positive numbers however impressive the numbers may be evaporates when multiplied by a single zero history tells us that leverage all too often produces zero even when it is employed by some very smart people the advice here is simple always invest in equities with the money that you save rather than the loans that you’re offered
7. control Your emotions
I don’t know who said this but there’s a quote that goes something like never reply when you’re angry never make a promise when you’re happy never make a decision when you’re sad in that same context let’s add another one which says never invest in equities when you’re emotional over time many studies have been conducted that prove that most investors behave irrationally in different situations which almost always leads to investment losses, in fact, one of the better literature on this subject is a talk by charlie Munger which is titled the psychology of human misjudgment where he goes on to explain 24 different cognitive biases and how they force investors to take poor decisions now an equity investor can take a few steps to control these biases and emotional factors while investing
- step one is to have a concrete investment plan which then ensures that you stay focused on your goals and that you don’t react emotionally to any kind of euphoric or despairing news
- step two for avoiding emotional distortion is to opt for a rule-based investment strategy which can be done by using passive funds or when investing via sip
- the third step in this process will be to diversify one’s portfolio across different asset classes.
- the fourth and final step one can take to control emotions in investing is to understand market history which can go a long way in managing one’s expectations and in curbing any overreactions during a market downturn or peak net I have said it before and I’ll say it again the biggest mistakes made, in equity investing are not analytical but behavioral so yes do mind your emotions
8. Long-term work best
equity investing works best when it’s done for the long haul and yes there will always be the temptation to book profits and take a punt jump into a particular sector a particular company etc but if you want to grow your wealth for the next few decades you will need to have a long-term mentality and a plan to go with it .
in fact, this entire long-term investing plan can be summarized in three simple phrases which are invested early invest regularly and invest enough so invest early is about getting a head start in the wealth-building process and allowing the power of compounding to complement the original investment that you’ve put in simply put the longer you are invested the more time your investments get to bloom and to bear fruits invest regularly is more about discipline and how small amounts of money injected on a regular basis can build a lot of wealth over the long term, for instance, simple yet effective advice to a 20-year-old will be to invest 3 000 rupees every month with an annual increment of one thousand rupees every year at a twelve percent annual return which would then grow his or her wealth to ten crore rupees over the next forty years and the third phrase invest enough is about goal planning which means one has to have a plan of action on one’s income expenses
future goals savings rate etc so that your tomorrow can be as good or even better than where you want it to be and with this principle which I hope you found useful.
