Tuesday, April 18, 2017

Income from your investments

Lots of us have bad experiences investing in the stock markets directly so would prefer the route of Mutual Funds. That is fine. The only problem I see is, Mutual Funds are skewed towards companies with higher market capital. That is to balance the risk-reward profile. As the assets of the fund grow, they find it difficult to earn higher returns than the index as their portfolio gets wider too. And each fund house has their own bias too. That is counter-productive. So all of this will lead to returns generated by mutual fund is almost comparable to index. Stock concentration gives higher returns than the market but can increase risk profile too. Is there a way, individual investors can manage their portfolio risks? Yes, if we can harness our emotions and invest with a sane mind.

o Have realistic expectations: We want to earn higher returns than benchmark index but we do not aim at windfall gains. Higher expectations makes us take higher risks and increase the chances of losing out. Capital protection is as important as growth.

o Give time: Think of portfolio creation like constructing a building. You cannot have rental income from a building which is not complete and it may take many months to years to complete and until then you are not expecting a return. And you are not judging the valuation of the building on daily or monthly basis during that period.

o Due diligence: Choose stocks wisely. Identifying fundamentally good stock with growth potential is a primary filter. Revenue and earnings growth have to be consistent and any deviation should have valid reasons. Risks in balance sheet should not be unhealthy. Cash flows have to be sensible and should triangulate with the state of business. Strategy as explained in investor presentations, conference calls, public interviews by the management should invoke confidence. Look at co-investors through share-holding pattern. Before you put money, spend time studying the company, their business, products, customers and competitors. The more time you invest here, higher is the quality of your portfolio.

o Techincals: Learn to identify supports and resistances. You may use chart patterns or look at option-chains or any other technical tools. Buy only at support levels. This will give a good start. If the stock falls after you buy and hits the stop-loss, it is better to get out. You did not study it well or you could not get the rhythm of that stock. Averaging it would potentially become a trap. Journey has to begin positively. Cut your losses at the first instance and retain those you get it right.

o Add only when there is price difference (and not every month): Do not buy in bulk but invest in small amounts. You will buy the next lot only when the stock moves up significantly and not periodically. If a stock stays at same level for months, there is no point in investing in it every month. We do not know the next move, it could be break-out or break-down. We are in the stock market to earn money which comes with price difference. Unless the positive price difference comes, it does not make sense to put additional money in the same stock. You may lose out on the initial rise if stock does well immediately after your purchase because your volumes were not high but you also avoided big loss potential too.

o Keep moving the stop loss level up:  This is to safeguard your profits. Since you have added more quantity only when the stock has moved up, there is a positive difference between your average price and the current market price. There is a always cushion of profits for your portfolio. But when the fundamentals change and you decide to exit, you should do so without incurring losses. Revising the stop loss levels up helps us to retain profits and realize them.

o Portfolio mix: We do not want to hold 50-100 stocks in our portfolio but wish to have around 10 stocks any given time. These stocks should not be from the same sector (for example, all should not be banking stocks or cement stocks). Ensure they are un-related, that would reduce industry risk. If regulator or the Govt. makes any policy changes, it should reduce the impact on the portfolio if the mix is not concentrated.

o Keep good cash: Keep some-thing like 30-40% of your portfolio in cash (it could be in the form of deposits or bonds or demat gold). Since stock markets surprise us often and give discount buying opportunities, we need to have cash (or equivalent) to make use of the opportunity. During your portfolio building years, you would not invest more than 70% of your money in equity. Once it begins to perform, you would book profits regularly to keep the cash levels at 30-40%. This may not look like efficient when the going is good but when there are shocks to market, the discount buying opportunities produce higher returns, this would give you an upper hand in the overall returns of the portfolio.

If you study the points listed above, we are doing everything right from identifying the quality stock, to entering at the right price, to managing the risks (credit risks, industry risks, portfolio risks) and also making good use of the opportunities.

If are too enthusiastic, you are likely to lose the money in the market so invest enough time until the euphoria is replaced with balanced perspectives. Then your investments will begin to produce positive cash flows. This journey will take at least five years. And you don’t learn to manage any business efficiently in lesser time than that.