Fortunes have been made in stock market, Warren Buffett, George Soros, John Templeton are some of the billionaire names. So how do these people made so much money while an average investor is still struggling? The answer lies in the mindset with which they invest. Here we are going to share some investment principles and disciplines an investor must follow:
Focus on the business before the price:
A stock is not just a ticker on your computer screen, behind every stock, there is a business. While in the short term, price of a stock is driven by demand and supply factors, in the long term, stock price is determined by the business performance. An investor should primarily focus on how well managed a business is. A business, that consistently performs well over a period of time, outperforms the market over the long run. As Warren Buffett says:
Invest with a long term horizon:
There is no such thing as overnight success, even if there is, it’s not sustainable. Success comes from discipline, consistency, persistence and most importantly patience. Don’t stay glued to your computer screen, a stock does not move because you own it. Money invested in a good business compounds over a period of time, giving investors above average returns. So find a great business, invest, stay with it for long term, and let the magic of compounding work in your favor.
Buy when there is blood on streets:
When markets fall, people panic, sell their holdings, fearing their losses will mount if they don’t act now. It sounds very logical as our ancestral knowledge tells us to run for safety as soon as a threat appears. Falling market is a disaster for an average investor, but its an opportunity for a patient investor. To understand this in a simple way, consider this example.
A shirt has a marked price of 100, for some reason you decide not to buy today and wait for few days. A week later, you find the same shirt being sold at a 30% discount, that is, at 70 a piece. Now, while the price of the shirt has changed, it does not change the fabric, the stitching, and the color of the shirt. This is a true bargain because the quality remains the same at lower price.
When markets fall, all stocks, irrespective how good their businesses are, fall with it. This presents a great opportunity for an investor to buy quality businesses at a bargained price, because when markets fall, price of the stock goes down while businesses’ earnings and profitability remains intact.
Do not over-diversify:
While diversification is a good way to mitigate your investment risk, over-diversification may hurt overall performance of the portfolio. When you have too many stocks in your portfolio, some or the other “bad apple” keeps dragging your overall portfolio performance, giving below average returns. The best way to diversify your portfolio is to invest in businesses that you understand. This not only helps understanding how a business makes money, it will also help you predict, with some certainty, how is the business going to perform in the future. Having fewer, but good quality stocks in your portfolio makes it easier to track their, and your financial performance.
Re-balance your portfolio to keep on track:
Rebalancing portfolio is a process of buying and selling assets once they achieve their potential. Portfolio re-balancing is also used to redistribute your capital among various sectors if one sector becomes dominant part of your portfolio. Lets understand this with the help of an example.
Let’s say your investments of Rs 100 is distributed in three major sectors, Power generation (Rs. 30), Steel manufacturing (Rs. 35) and cement sector (Rs. 35). According to present asset allocation, this is how your portfolio will look like on a pie chart.
after few years, you discover that cement sector has outperformed other sectors. While steel sector has given 10% return, power 14%, but cement sector has given 71% return. The pie chart prepared after accounting for returns received looks like this:
As it can be seen from the chart above, cement sector after its significant rally forms 45% of the entire portfolio. If in future, cement sector sees a correction, and your portfolio remains over exposed, you may lose significant portion of your invested capital. To mitigate this risk, some profits must be booked by selling cement stocks and proceeds from it should be used to invest elsewhere.
In this way your portfolio not only remains balanced, periodic profit booking and reallocation appreciates your portfolio value faster.
Investing is very simple, you don’t have to be a professional financial analyst, neither you need complex methods or formulas to execute your investment plans successfully. To be a successful investor all you need is patience, persistence, and discipline. With these traits, any investor can outperform the markets in the long term.