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What could be the worst scenario an investor can face when investing in the stock market?

The worst thing that can happen, is permanent capital loss! If everyone understands and accepts this painful fact then the next step is to mitigate that risk and change their style of investing.

So, what is the biggest mistake investors do? My opinion, they unknowingly take the cues from the prices of the stocks. If the price of one stock is going up, they assume that it is a good stock and they buy it. Similarly, when the price of any stock keeps falling down they think that it is a bad stock and they sell it.

So it is all about taking cues from the prices of the stocks, and this is accessible freely from anywhere. I call it free zone. In short run these prices react to every available information in the market and unfortunately most of that information is not even closely related fundamentally to the businesses.

The worst part is that the investors react to the price changes and take decisions that takes them to the path of permanent capital loss. I have heard from many investors that they sold their holdings in a business because they got scared when the price fell down! It is high time for the investors to consider these stocks as business or enterprise and not just a piece of trading paper. At the same time it is important to understand that you should be a part of quality business not big businesses to make money.

Looking into investing money with fund management businesses (mutual funds), they do not focus on your returns but only on how to beat the market returns. The industry has been designed such, that even the cold faced fund managers are not given a choice to react when they know that the markets are expensive. They have to stay invested because they have to simply follow the process that was designed by their bosses.

This process of the industry does not make sense to me. We value each and every business trading on the National Stock Exchange and can see clearly and understand when the market is trading expensive or discounted. As soon as we come to the realisation that market is trading overly expensive, we do not hesitate to convert our holdings into cash.

Investors should not hesitate to sit on cash if they feel the market is giving unrealistic prices. Two years ago we thought that the market was trading expensive and eventually it fell from 5500 down to almost 4900 and similarly a year ago when it was trading at around 6000, we waited for it to fall down to around 5500. We had not anticipated these falls but as they happened we knew which stocks to pick at what price.

It is important here to emphasize that our approach is from the bottom up. We analyse, and do our research on enterprises and when we think that they are trading in market below their intrinsic values we accumulate them. We do not invest depending on the market conditions.

So how can investors harness superior returns from the market? There are three important things that need to be done. First, they need a right framework. When I say the right framework, it means you need to think about the market correctly and stop thinking about it conventionally. Not all blue chip companies are blue chip. Good businesses come in all sizes and that is the reason not all the big businesses are blue chip.

The second, is to invest in good quality businesses. These businesses are fundamentally strong and have bright future prospect. Good businesses do not only display growth in their earnings but also generate high returns on their equity. Best businesses are the ones who take large amounts of capital from shareholders and reinvest them to achieve higher returns. On the other hand the bad quality businesses do totally opposite.

Finally the third thing to do is to find the value of those good businesses. What you pay to buy those businesses is the price, not the value of that business. To achieve higher returns on your investment in the long run, you have to buy those assets when they are trading cheaper than its intrinsic value.

If you follow the above three rules, there is no one to stop you to achieve superior returns.