The Why and How of equity investment growth

In the last post I had explained why the growth in equity cannot be linked to the logic of compounding. I hope that many of the readers have now cleared their basic misconception on that, at least much of the feedback I have received leads me to believe so. This however, should not be taken to mean that equities are not the asset class for growth. Far from it – as you can see from some of the earlier posts in this blog, as an asset class it has shown maximum growth over long periods of time. In order for you to successfully invest in equity, two things are important. Firstly, you need to understand why equities have the potential to earn great returns and secondly, you must have a way to benefit from this while controlling your risks.

The why part of it is relatively simple. Stock prices are dependent on the underlying businesses that they represent. If the businesses have an established track record and/or have a great future outlook then the stock is likely to do well. You can again go back to the series of posts on equity as an asset class and read the ones on stock pricing. It is important to understand here that stocks do not have a floor or a ceiling to their price. There are numerous examples where a once valued stock loses all value and the exact opposite of that. Over a period of time the stock price will reflect the true worth of the business. There can be short term mismatches due to perceptions about the business but these are not sustained.

If you understand the above then you will see the logic of why you need to understand businesses well in order to be a successful equity investor. It is not about calculating ratios and poring over complicated looking graphs. Most of that will only track history whereas stock prices are really determined by the future business potential of the company. I would go on to say that for being a successful investor understanding of the broader economy, the industry and finally the company is imperative. Financial statement perusal and their interpretive analysis can also provide good insights but this is not something you need to do yourself. There are several others more qualified and knowledgeable than you in this respect who are doing this for a living. Just use their expertise to your benefit instead of trying to reinvent the wheel unsuccessfully.

Many have asked me the question on how to select stocks etc. I have answered this in earlier posts, which you will need to go and read. However, no matter how careful you are about selecting a particular stock to invest in there is really no guarantee that it will be a winner. Think of companies like Kingfisher Airlines, Reliance Communications that were almost a certainty to do well but their investors have lost money heavily. So whether you are a savvy investor on your own or a Fund manager with a whole lot of resources at your disposal, there is a real risk of losing money in a particular stock.

This brings us to the central point on how we should invest in equities so that we can benefit from the likely growth but can be protected to some degree from the inevitable risks that are associated with it. Well, you can try out the following strategies. My explanation here will be brief as I intend to cover these in much greater detail later on.

  1. You do not need to bet on single stocks for your investment. The risk reduces significantly when you build a portfolio of stocks within the sector and across sectors. An investor having investments only in Satyam in 2010 would have been affected very badly. The same investor having a portfolio of stocks that had other IT companies in it would have been a lot better off.
  2. If you do not feel you have the skills, time or energy to build a portfolio you can look at investing in Mutual funds. There is some work you need to do here too, but the work on stock selection and risk containment is mostly done by the fund manager for a fee.
  3. In case you have substantial assets to invest in stocks you can avail the services of a good PMS. They will invest for you and your interaction can be fairly limited if you are associated with good people.

With one or more of the above in place the risks are contained to a great degree. Yes, there is still risks of losses as the nature of the asset class is such. However, using one of the above mechanisms and willingness to invest for a long time reduces the risk of losses considerably. At the same time, you have the potential of substantial gains.

You make money in equity not by compounding logic – you do it by understanding the businesses, diversifying your investments, choosing the right approach and being willing to see things through for the long haul.

I will get into details of building a portfolio in my future posts.

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