08 Mar, 2020
Everyone is looking for a quick and easy way to riches and happiness. It seems to be human nature to constantly search for a hidden key or some esoteric bit of knowledge that suddenly leads to the end of the rainbow or a winning lottery ticket.
While some people do buy winning tickets or a common stock that quadruples or more in a year, it is extremely unlikely, since relying upon luck is an investment strategy that only the foolish or most desperate would choose to follow. In our quest for success, we often overlook the most powerful tools available to us: time and the magic of compounding growth. Investing regularly, avoiding unnecessary financial risk, and letting your money work for you over a period of years and decades is a certain way to amass significant assets.
Here are several tips that should be followed by beginning investors.
1. Set Long-Term Goals
Why are you considering investing in the stock market? Will you need your cash back in six months, a year, five years or longer? Are you saving for retirement, for future university expenses, to purchase a home, or to build an estate to leave to your beneficiaries?
Before investing, you should know your purpose and the likely time in the future you may have need of the funds. If you are likely to need your investment returned within a few months, consider another investment; the stock market with its volatility provides no certainty that all of your capital will be available when you need it.
By knowing how much capital you will need and the future point in time when you will need it, you can calculate how much you should invest and what kind of return on your investment will be needed to produce the desired result.
Remember that the growth of your portfolio depends upon three interdependent factors:
- The capital you invest
- The amount of net annual earnings on your capital
- The number of years or period of your investment
Ideally, you should start saving as soon as possible, save as much as you can, and receive the highest return possible consistent with your risk philosophy.
2. Understand Your Risk Tolerance
Risk tolerance is a psychological trait that is genetically based, but positively influenced by education, income, and wealth (as these increase, risk tolerance appears to increase slightly) and negatively by age (as one gets older, risk tolerance decreases). Your risk tolerance is how you feel about risk and the degree of anxiety you feel when risk is present. In psychological terms, risk tolerance is defined as “the extent to which a person chooses to risk experiencing a less favorable outcome in the pursuit of a more favorable outcome.” In other words, would you risk Tk. 1000 to win Tk. 10,000? Or Tk. 10,000 to win Tk. 10,000? All humans vary in their risk tolerance, and there is no “right” balance.
Risk tolerance is also affected by one’s perception of the risk. For example, flying in an airplane or riding in a car would have been perceived as very risky in the early 1900s, but less so today as flight and automobile travel are common occurrences. Conversely, most people today would feel that riding a horse might be dangerous with a good chance of falling or being bucked off because few people are around horses.
The idea of perception is important, especially in investing. As you gain more knowledge about investments – for example, how stocks are bought and sold, how much volatility (price change) is usually present, and the difficulty or ease of liquidating an investment – you are likely to consider stock investments to have less risk than you thought before making your first purchase. As a consequence, your anxiety when investing is less intense, even though your risk tolerance remains unchanged because your perception of the risk has evolved.
By understanding your risk tolerance, you can avoid those investments which are likely to make you anxious. Generally speaking, you should never own an asset which keeps you from sleeping in the night. Anxiety stimulates fear which triggers emotional responses (rather than logical responses) to the stressor. During periods of financial uncertainty, the investor who can retain a cool head and follows an analytical decision process invariably comes out ahead.
3. Control Your Emotions
The biggest obstacle to stock market profits is an inability to control one’s emotions and make logical decisions. In the short-term, the prices of companies reflect the combined emotions of the entire investment community. When a majority of investors are worried about a company, its stock price is likely to decline; when a majority feel positive about the company’s future, its stock price tends to rise.
A person who feels negative about the market is called a “bear,” while their positive counterpart is called a “bull.” During market hours, the constant battle between the bulls and the bears is reflected in the constantly changing price of securities. These short-term movements are driven by rumors, speculations, and hopes – emotions – rather than logic and a systematic analysis of the company’s assets, management, and prospects.
Stock prices moving contrary to our expectations create tension and insecurity. Should I sell my position and avoid a loss? Should I keep the stock, hoping that the price will rebound? Should I buy more?
Even when the stock price has performed as expected, there are questions: Should I take a profit now before the price falls? Should I keep my position since the price is likely to go higher? Thoughts like these will flood your mind, especially if you constantly watch the price of a security, eventually building to a point that you will take action. Since emotions are the primary driver of your action, it will probably be wrong.
When you buy a stock, you should have a good reason for doing so and an expectation of what the price will do if the reason is valid. At the same time, you should establish the point at which you will liquidate your holdings, especially if your reason is proven invalid or if the stock doesn’t react as expected when your expectation has been met. In other words, have an exit strategy before you buy the security and execute that strategy unemotionally.
4. Handle Basics First
Before making your first investment, take the time to learn the basics about the stock market and the individual securities composing the market. There is an old adage: It is not a stock market, but a market of stocks. Your focus will be upon individual securities, rather than the market as a whole. There are few times when every stock moves in the same direction; even when the averages fall by 100 points or more, the securities of some companies will go higher in price.
The areas with which you should be familiar before making your first purchase include:
Financial Metrics and Definitions. Understand the definitions of metrics such as the P/E ratio, earnings per share (EPS), return on equity (ROE), and compound annual growth rate (CAGR). Knowing how they are calculated and having the ability to compare different companies using these metrics and others is critical.
Popular Methods of Stock Selection and Timing. You should understand how “fundamental” and “technical” analyses are performed, how they differ, and where each is best suited in a stock market strategy.
Stock Market Order Types. Know the difference between market orders, limit order, stop market orders, stop limit orders, trailing stop loss orders, and other types commonly used by investors.
Different Types of Investment Accounts. While cash accounts are the most common, margin accounts are required by regulations for certain kinds of trades. You should understand how margin is calculated and the difference between initial and maintenance margin requirements.
Knowledge and risk tolerance are linked. As Warren Buffett said, “Risk comes from not knowing what you are doing.”
5. Diversify Your Investments
Experienced investors such as Buffett eschew stock diversification in the confidence that they have performed all of the necessary research to identify and quantify their risk. They are also comfortable that they can identify any potential perils that will endanger their position, and will be able to liquidate their investments before taking a catastrophic loss.
The popular way to manage risk is to diversify your exposure. Prudent investors own stocks of different companies in different industries, sometimes in different countries, with the expectation that a single bad event will not affect all of their holdings or will otherwise affect them to different degrees.
Imagine owning stocks in five different companies, each of which you expect to continually grow profits. Unfortunately, circumstances change. At the end of the year, you might have two companies (A & B) that have performed well so their stocks are up 25% each. The stock of two other companies (C & D) in a different industry are up 10% each, while the fifth company’s (E) assets were liquidated to pay off a massive lawsuit.
Diversification allows you to recover from the loss of your total investment (20% of your portfolio) by gains of 10% in the two best companies (25% x 40%) and 4% in the remaining two companies (10% x 40%). Even though your overall portfolio value dropped by 6% (20% loss minus 14% gain), it is considerably better than having been invested solely in company E.
6. Avoid Leverage/Margin Loan
Leverage/Margin loan simply means the use of borrowed money to execute your stock market strategy. In a margin account, banks and brokerage firms can loan you money to buy stocks, usually 50% of the purchase value. In other words, if you wanted to buy 1000 shares of a stock trading at Tk. 100 for a total cost of Tk. 100,000, your brokerage firm could loan you Tk. 50,000 to complete the purchase.
The use of borrowed money “levers” or exaggerates the result of price movement. Suppose the stock moves to Tk. 200 a share and you sell it. If you had used your own money exclusively, your return would be 100% on your investment [(200,000 -100,000)/100,000]. If you had borrowed Tk. 50,000 to buy the stock and sold at Tk. 200 per share, your return would be 300 % [(200,000-50,000)/$50,000] after repaying the Tk. 50,000 loan and excluding the cost of interest paid to the broker (which is usually 16% and over).
It sounds great when the stock moves up, but consider the other side. Suppose the stock fell to Tk. 50 per share rather than doubling to Tk. 200, your loss would be 100% of your initial investment, plus the cost of interest to the broker [(50,000-50,000)/50,000].
Margin is a tool that can go extremely bad in a stock market like Bangladesh.