You must not forget these 3 rules of equity investing

It has never ceased to amaze me how people with a high level of intelligence and very successful in their profession or work, can sometimes get it so completely wrong when it comes to understanding the basic characteristics of equity investing. Now that my blog is getting a lot of traction, I keep interacting with many people where this becomes more evident. The other day when I was trying to explain equity investment rules to a friend, he wanted to know what are the top 3 rules that one had to keep in mind. The motivation of this post comes from that discussion.

The first rule is simple – Equity returns do not compound. Now, I know you may have read in scores of blogs and heard from many financial planners that they do, but it does not matter. What is wrong will remain wrong, irrespective of how many people tell it and how vehemently they do so. If you are interested in details, look at another blog post of mine where I have written about it with clear reasoning as to why the returns from equity do not compound. What is the upshot of this?

The second rule that follows from the first is this – What time you invest in equity is not important, what really matters is the level at which you invest. This is easier to understand as you must have faced it many a time when investing in SIP. You may invest in an MF with NAV of 14.5 per unit in July 2015 and suddenly see the NAV slipping to 13.4 per unit in 2 months time. Obviously, no one can definitively predict the market, but to say that you should just keep investing at a monthly frequency, irrespective of what is happening to the market is surely not correct at all. That would be true for debt products, where the earlier you invest the more returns you are likely to get, for there the returns do compound. Let us say the Nifty is at 8200 today and from the broad trends I know that the probability of it falling to 7800 in the next 2 months is quite high – should I still wear my blinkers and keep contributing to my monthly SIP? No way.

The third rule of equity investing that you must never forget is this – Never put yourself in a situation where you have to redeem your equity investments in a bad market. We all know that we are investing for our goals and when the goal comes we need to redeem our financial investments in order to meet the goals. However, if you are in a bad market you may somehow see your portfolio erode greatly at the time of redemption. This really is the greatest risk in equity investments, when by selling in a poor market you convert your notional losses to real ones. Again, if you are interested you can search the blog and read some posts on this topic and how you can avoid being in this situation. The only practical way is to have a corresponding debt portfolio that you can tap into, should such a market situation arise.

This then are the 3 rules of equity, never to be forgotten. How do you implement them in real life? There are many ways to do it but let me give some pointers that you can easily use.

  • Start investing in debt products like PPF first – unlike equity returns, debt returns do compound handsomely over a long period of time. Fortunately PF is compulsory for most of the people in the organized sector.
  • Create a parallel strong debt portfolio along with your MF and stock portfolio. This will obviate the need of redeeming equity in a bad market, which is really the riskiest part of equity investing.
  • Come out of the mindset that you must invest 5000 or 10000 every month in a particular fund for donkey’s years to get anywhere with your goals. Regular investment in equity is a good practice but there is no need at all to be rigid. If you are investing 1,20,000 a year in a fund, you can still do the same in a much more productive manner.

For people interested in knowing more about all that I have referred to here, without getting into the details, I urge you to explore the blog and read through the posts on Stocks, MF, SIP and Goal based financial planning. It may completely change the way you are investing right now.

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8 thoughts on “You must not forget these 3 rules of equity investing

  1. compounding cannot be completely ruled out – e.g. dividend declared y-o-y may compound, profit retained in a business may compound resulting in bonus shares, share value/market cap may itself compound as the equity base/book value improves, etc.

    DEFINITION of ‘Compounding’ The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings.

    What you probably meant was there is no guarantee on the rate at which the share price may compound 🙂

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    • No, equity returns simply do not compound. All stocks do not give dividends and there are umpteen cases where the stock has simply run aground.

      Equity has growth, but not compounding, whose technical definition really is “growth on growth”. For equity loss is as likely as gain, so the issue of compounding simply does not arise.

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  2. Sir,

    My name is Justin. Working in KSA. I have SIP in 6 MF from last 3 year & using my current NRO account for SIP purchase. Recently , I had received KYC updation form. Any Tax implication for regarding SIP purchase thru Current NRO account?

    Regards Justin Joseph

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  3. I don’t SIP and I don’t invest in MF. I don’t have FDs. I invest in stocks whenever I have money & invest in some decent stocks. One important thing that I have learnt is not having enough money at right time to invest in stock that you zeroed on. That leads to lost opportunity. So I think , it is very important to have at-least invest-able 10% liquid cash to dip in.

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  4. “from the broad trends I know that the probability of it falling to 7800 in the next 2 months is quite high” : I doubt how many times these broad trends have got it right. And that is where the second rule is flawed.

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    • Broad trends do prove right more often than not. But that is really not the point at issue here – the point is standard SIP of the same amount irrespective of the market situation is not logical at all. The second rule is therefore not flawed – returns from your investments depend on the levels at which investments are done and not really on the time. Show me how this is flawed.

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  5. Hi Rajshekhar,

    Even though I am regular reader of your blogs, I personally believe you should restrict frequency of your blogs. Readers should eagerly wait for your next blog. Off late you have posted too many blogs within short period of time. This is just my personal opinion.

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  6. I have been thinking on an approach where the debt allocated money is transferred to equity whenever there is a correction in market and then reload the debt slowly by increasing the SIP to debt. Not sure if this will really workout though since 1. we really do not know when the bottom of market is reached. 2. It requires continuous tracking of market (on a daily basis). Do you have any thoughts on this?

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