If I ask a question, what I need to invest in the stock market?

The simple answer is, you need money in your bank and one demat account attach to it with access to any online platform to execute your trade. The process of buying and selling stocks (transactions) is easy and tempting but investing is not that easy.

So after setting up all the accounts, the next logical question comes to investors mind is, which stocks to buy?

Investment framework

Investing is a zero sum game. This means if you made money in the stock market then there is someone somewhere who lost its money same time. Market returns are the average returns of all the investors participated in the stock market. Hence it also means if market has given 20% return in any year, there might be few stocks which underperformed for that time frame and few outperformed.

From professionals point of view, you are really good investor if you beat market returns (benchmark) every year. Most of the fund managers in India from mutual fund industry have no issue beating the stock market returns so far. This is because the money invested in the stock market through mutual fund represents today less than 10% of the total market. We came to that figure after reading this two articles online. Click here and here to read them.

If we compare that figure with any developed countries, from whom we hear too often that it is tough to beat the market returns, to give perspective, in Australia like in any developed countries around the world, managed funds manage in range of 50% – 60% of the total market. So there is a 50% chance that on the other side of your trade you are against a professional who has all the resources and infrastructure to come to his/her opinion on that transaction.

As our investment pool of mutual funds will grow its market share, they will find it difficult to beat the average returns of the market in the future years.

Market returns

It is impossible to beat market returns every year. It is not you, but the nature of the market itself. Last year when I was reading this book, “The success equation: Untangling skill and luck in the business, sports and investments” the author Michael J Mauboussin shared his analysis on various activities and what part of luck and your skills play to be successful.

Luck plays almost 85% and your skills only 15% to be successful investor in the stock market.

We can make luck work on our side if we work and build the process to identify stocks which have higher probability to beat the average market returns and buy them more when they look cheap and sell them when they look expensive.

Your investment plan is not required to beat the market returns every year, and it will not. But it should be good enough to beat market returns in the long term like 10, 15 and 20 years.

So do you have an investment plan about which stocks to buy? When to buy? Hold? And Sell?

Investment Plan

I will share my investment plan to guide you to build your own. I will divide my investment plan in three parts:

  1. Stock Selection
  2. Valuations
  3. Maintenance of portfolio (Re-balancing)

Stock Selection

So which companies have big chance to outperform and beat average market returns? If we shut down the stock market and think of businesses then what kind of businesses do you want to own?

We want to own businesses:

  • Where they have no or less debt on their balance sheet
  • Generating higher returns on the shareholders equity and
  • Generating surplus cash flow from its operations to pay all the bills, dividends and reinvest remaining to grow its earnings at healthy rates.

In short we want you to only invest in the quality stocks where chances of them to face adversities is less. This will help you to avoid impairment of your capital.

Valuations

I can write the whole article on valuations but let us focus on valuations band we share many times with you on our blog.

It is very hard to value any stocks accurately without knowing the accurate numbers. We cover all the stocks where there are independent analysts and brokerage houses who have their views on its future earnings. We collect all that information and their views and run our own valuation process and come up with its valuation range.

For example, this week we shared our view on Tech Mahindra stock and we found a big variance in its 2018 profit expectations. Few expect them to report profits lower than Rs 2,500 crore and few expect them to Rs 4,500 crore.

So if bear analysts are right then its valuations can fall to as low as Rs 200 as per our calculations and if bulls turn into reality then its values rises as high as Rs 700. So what should we do when it is trading at Rs 400 now?

We pretty sure that its 2018 valuations are going to be within those range (Rs 200 – Rs 700). If you don’t have enough time to do research, and plan to buy today at Rs 400 than get ready to take risk of its stock price to fall down by 50% from here on to Rs 200. Else, if luck plays on your side then find its stock price flying as high as to Rs 700.

Our stock market allocation meter suggest not to invest more than 60% of your allocated money to this stock.

So if you had plans to invest Rs 100,000 with Tech Mahindra then you should not invest more than Rs 60,000 with it today at that price. This means in other words, you are okay to book losses of Rs 30,000 in worst case scenario from this transaction. If not, rethink and allocate the right money that you are comfortable to lose.

However, looking at past history of Tech Mahindra’s capital allocation and its performance, we are not 100% confident that the management will be able to ride out of this situation positively. Our conviction level at this stage is only 50% with them. So the most we are happy to invest is only Rs 30,000 (50% of Rs 60,000) with Tech Mahindra and are willing to lose not more than Rs 15,000 from this transaction.

As it is said, “the higher the price you pay, the lower is your returns and lower the price you pay, then higher is your returns”.

It makes sense to buy closer to Rs 200 levels and sell at Rs 700 for Tech Mahindra stocks. But what chances are for it to come close to Rs 200 today? Not much, so it makes sense to have a bit of exposure to it if you have even little conviction to this investment story.

So my investment plan takes calculated risk and I am fully aware of my expectations from my investments every time. it helps to keep the emotions away from the investment decision.

Maintenance of your portfolio

The worst thing to do in the stock market is to invest and forget about it. You need to be very disciplined in your process of stock investing and should know exactly what to do every time. Many investors forget to add this step in their plan and could not figure out what went wrong.

There are three scenarios that can happen in the stock market after your investment. Both your stocks and market fly high, go down or do not change. Your plan should be so specific that it should tell you what to do in all those scenario.

Let us take the same example of Tech Mahindra. So after buying at Rs 400, we found its stock price falling down to Rs 300. Market has crashed!

What will you do?

Sell?

Hold?

Or buy more?

Let us assume our stock allocation meter is now saying not to invest more than 80% of your allocation. So now you have Rs 20,000 worth more to buy at current price. If nothing has changed, our conviction levels are same then definitely we will buy Rs 10,000 worth more at Rs 300.

But if our conviction level falls down to say 25% than we will sell Rs 10,000 worth of our investments and book losses.

But if its stock price jumps up to Rs 500. Then what?

Sell? Or hold?

Let us assume that at Rs 500 our stock allocator meter is pointing towards not more than 40% of allocation then definitely you should sell one third of your holdings and book profits.

You should re-balance your portfolio regularly. Professionals like me re-balance our portfolio every month. Investors should re-balance at least once in year. There is a cost involved in re-balancing so make sure it is economical to re-balance frequently.

My advice will be not to do more than 4 times a year.

Conclusion

When luck plays bigger part in the results, it is important to have a balanced process and tools to help you manage and invest your portfolio. If you don’t have any plans and process and entirely dependent on your luck for your investment returns then you might never know when it will leave your side and crash your dreams and your savings pool.

Invest in high quality stocks, buy them when they are trading within the valuation zone as per asset allocation meter with your conviction in that story and maintain it regularly by re-balancing it. You will find most of the time on the other side of average market returns.

The approach that I have shared with you above is tested and have beaten the market returns in the long term.

What is your investment plan? Share with us.