Rules of Equity Investing: Explained For Beginners

The post aims to highlight to its readers the basics of the stock market. For people who want to build wealth by the equity route (mutual funds, stocks), the knowledge of the rules of investing is key. Beginners who are starting in the stock market will certainly benefit from the information. For experienced investors, it can be a refresher article. For quick answers, read the FAQs.

Introduction

I’ve been reading about stock investing since the year 2008. When I bought my first stock, I did not know even the basics of the stock market. I just bought stocks to sell them at a profit. I soon realized that what I was doing was trading and not investing. But I was also reading a book called The Rich Dad Poor Dad. It taught me about the necessity of asset building and the concept of financial independence.

These two learning taught me, that the focus should be on building an investment portfolio and not on short-term gains. I also became aware of my inherent liking for stocks. Hence, I started learning the process of stock investing organically. During that time I came to know about the legendary investor Warren Buffett and his investment style of value investing.

Value investing pointed me toward fundamental analysis. It also taught me that a stock’s price can be valued. The focus on price valuation forced me to look at a stock’s underlying business. For that, I had to read the company’s reports.

The next step was to learn to read and interpret the company’s financial reports. It was the most challenging lesson to learn. It took me some time to understand and correlate the numbers in the reports. However, passing this challenge gave me the ability to estimate the intrinsic value of stocks.

As the accuracy of my intrinsic value estimation improved, a strong investment portfolio was building underneath. It was a self-enforcing cycle. The more I read, it helped me to build a stronger investment portfolio.

These sequential learnings about the stock market basics, in this specific order, helped me to discover these rules of investing. Let’s read more about them.

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Why To Follow Rules

The effectiveness of these rules is timeless. These rules are tailor-made for such investors who buy stocks to hold them for years in the portfolio. Such people prefer buying “stocks of strong companies at the right price.” But in practice, such a simple-looking statement becomes complicated while implementing. Why?

Because, out of about 5000 numbers stocks listed in the Indian stock market, the majority carry weak fundamentals. It is a fact, that investible stocks are in a thin minority. Moreover, most good stocks trade at overvalued price levels most of the time. To make the task even more difficult, the know-how of stock analysis, about the procedure to do price valuation, is scarce among investors.

This is why understanding these rules becomes a necessity. One cannot build a winning stock portfolio by ignoring these rules. Following them makes even beginners execute stock investing like a professional.

What is the bigger purpose? The knowledge of these basic rules will help one to build a strong investment portfolio. The stocks included in the portfolio are quality assets that can be held for decades. The accumulation of such assets can help one achieve the ultimate goal of financial independence.

#1. Do The Opposite of What The Market Is Doing

This style of investing is called contrarian investing. It is an investment strategy using which investors make buy-sell decisions that are in contrast to what the majority are doing in the market. It means, when others are selling stocks, you buy and vice versa.

What is the logic?

• In a bull market, there are more buyers of stocks than sellers. This takes the price of individual stocks up. Increased buying makes good stock overvalued. Hence, during such times, it is better to book profits by selling weak, overvalued stocks in the portfolio.
• In a bear market, the general sentiments of the market are cautious or negative. More people are selling stocks than those are buying. Increased selling makes the prices fall to undervalued levels. Hence, during such times, a trained investor would buy quality blue chip stocks.

Prepare a watchlist of stocks included in the indices of Sensex, Nifty50, and Nifty Next 50. The purpose should be to buy those stocks from this list when the index is correcting or crashing.

#2. Buy & Hold For A Long Term

The stocks you’ve bought in step #1 are the best quality stocks in the stock market. It will be needless to buy them today and sell them for 15-20% gains in times to come. These stocks have the potential to compound at the rate of 15%+ each year. For example, the price of Britannia rose at an average rate of 25% each year in the last 20 years.

One must buy stocks to take advantage of the power of compounding. Let’s take an example.

• Quick Selling: Suppose, 20 years back in Jan’2003, you invested Rupees one lakhs in the stocks of Britannia. By Sep’2004, the price of it rose by 30% and you decided to sell the stock. Hence, you pocketed Rupees thirty thousand in profits.
• Holding: But consider this, had you held on to it till today, what would have been your gains? In these 20 years, at a rate of 25% CAGR growth, the invested one lakh would have become Rupees eighty-eight lakhs.

Just by holding on to this stock for the long term, you could grow your invested capital by eighty-eight times. Read more about buy and hold investing.

#3. Keep a Diversified Portfolio

Spreading your money into multiple non-related assets is necessary. For retail investors, there are four main types of assets one can invest in. They are equity, debt, gold, and real estate. Every time you buy equity, simultaneously add another asset type to the portfolio. Being too heavy only in one asset type is too risky.

How to do it?

Suppose you bought stocks of a company worth Rs.10,000. Now, it is time to diversify your portfolio by investing at least Rs.5000 (50% of equity) in another asset type. If you are unsure about where else to invest the money, at least buy a bank’s fixed deposit.

This way the size of your investment portfolio will be Rs.15,000 with 66% parked in equity and about 34% parked in debt.

These days there are multiple alternatives available that can be used for online investing from the comfort of our homes. In debt space, one can use debt funds. For gold, the use of gold ETF or gold funds is possible. Though real estate properties are very capital intensive, investing in properties through REITs makes it very convenient for retail investors.

>> To Know more about the available investment options, read here.

#4. Expect Realistic Returns

When people are first exploring the stock market, their return expectations can be skewed. The stock market is not a place where you come to double the money in a quick time. It is a place where professionals invest and stay invested for decades. A realistic return one can expect from the stock market is about 10-20% per annum.

Investing in troubled times like COVID or the 2008 crisis, one can see capital appreciations as high as 100% in a matter of 12-18 months. But these are only one-off examples. As a rule of thumb, the markets crash every 10 years and there are big corrections every 3 years.

• Crash: Investing during a market crash can earn the highest returns. But care must be taken in a market crash. One must try to buy only when the index is close to its bottom. Such times are most suited to accumulating high-moat stocks. Once invested, such quality stocks must be held for a very long time like ten-plus years. In such a scenario, a return expectation of 25% per annum will be realistic.
• Corrections: Investing during corrections can earn an above-average return. Corrections are times when one can increase the weight of stocks accumulated during the crash. If the price of the holding company corrects by about 8-10%, it is a good buy opportunity. Again, the stocks must be bought with a holding intention of 10+ years. In such a scenario, a return expectation of 15% per annum will be realistic.
• Normal Times: Most of the time, stocks and mutual funds trade in this zone. Investing during these times can be tricky as the market is trading mostly flat. A beginner can wait for 4-5% correction and add on to their existing holdings. Experienced investors can buy stocks trading at a discount to their intrinsic value. Stocks picked during such times can yield annualized returns of 10% per annum in the long term.

Here are the average returns of the market in the last 5 years. BSE500 index 10.2% per annum. BSE200 index 10.6% per annum. BSE100 index 10.7% per annum. Nifty 11.3% per annum. Sensex 12.3% per annum.

#5. Sell Stocks of Weak Companies [Early]

No matter how carefully one picks stocks, some weak ones will creep into the portfolio. The first step is to realize that there are a few weak ones in the holdings. Once such stocks are identified, the idea should be to sell them at the earliest. Delaying the sell decision will only lead to more downside risk in the time to come.

The idea of building a stock portfolio is to create an asset base that can be held for decades. With this philosophy in place, there is no point in holding on to weak companies. But there are two main challenges in implementing this idea:

• Identification of Weak Companies: Here are a few indicators that are readily visible in the annual report. The first sign of weakness is falling revenues and net profits. The next important indicator of weakness is negative net worth growth and a falling asset base. Another conclusion can be derived from the cash flow report. A falling or negative net cash flow from operations is a strong sign of weakness in business fundamentals.
• When To Sell: Timing the sale of such stocks is not easy in expectation of a reversal. But more often than not, the price movement of such stocks is mostly downside. Hence, it is better not to hold on to such stocks till their fundamentals are weak. So, as soon as the investor makes a first note of the weaknesses, the stock shall be sold.

As important as it is to include good stocks in the portfolio, it is equally critical to get rid of the weak ones.

>> To Know more about timing the sale of stocks, read here.

Conclusion

These rules of stock investing are derived from the popular Stock Market Basics known to all investors. But what I’ve presented here are my interpretations of them. I’ve been learning and practicing stock investing for almost one and a half decades now. These rules work.

FAQs

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