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Thursday, July 17, 2008

Investing in the stock market ... science or art?

This is probably the best time to write this post - what with the sensex at its 52 week (or is 72 week) low, most emerging market indices down anywhere from a third to half their value about six months ago. Every business news website is speculating on whether this is the bottom or is there more to come. This is the first of two parts on how to invest in the stock market. It's called the Lazy Man way of Investing. This is for those who do not have the time to research and invest in stocks or Mutual Funds.

Q. How to begin investing?
A. Start investing a fixed amount however small in an Index fund or mutual funds via SIP. This takes care of two things - One - it provides the discipline of investing i.e. no temptation to invest more in a rising market to burn more than is necessary and two - not investing in an under-valued market and lose on the upside. Two - It provides averaging which ensures that your overall costs are not skewed toward

Q. What about Mutual Funds?
A. In a developed market like the US, an index fund is probably the better choice due to the lower costs and better overall performance. But these are still not that well-established in emerging markets. So a mutual fund which has a good performance over the past 8-10 years and has outperformed the market consistently is a good choice. Take care to look at hidden costs in the performance description and look at performance after costs to see if they out-perform the market.

Q. Growth or Dividend MFs?
A. Growth - Helps grow the nest egg much faster rather than pay taxes for dividends and reduce the upside.

Q. How many MFs?
A. 5-10 MFs divided across key sect

Q. What about the hot stock that my friend recommended?
A. Even if your friend has an IQ of 175 and is the whiz of Stock Investing, I'd personally recommend you do not go for it. For one, it shows you are not taking responsibility for your actions by blindly following. Even if there's a tip, find out why he feels this stock will rise, see if its close to its 52-week high (a warning sign of speculation), and do your due-diligence before investing.

Q. What about stocks?
A. Stocks surely provide better returns if you do enough home work before investing. For one, the costs are lower if you do not keep buying and selling stocks on a daily basis (which is a sure no-no for investing). In fact it is not called investing (does speculation sound familiar?) and there is a lot more opportunity to find under-valued stocks that will provide a much greater upside.

Q. Standard checks before buying a stock?
A. Strong Earnings, Consistent Growth, Honest Management, History of utilizing Retained Earnings effectively, History of Share Buy-Back, Low P/B ratios. Do your own valuations using standard techniques and buy stocks that are trading at a sufficient margin of safety (2/3 recommended). In summary, if you do not have the time to do some or most of this, try to stay away from stocks till you have the time.

Q. What about high-dividend yield stocks?
A. Very good way of picking some wonderfully under-priced stocks. In fact right now, some stocks in the sensex have current dividend yields of 8-10% and are big names in their sector and have either consistent or growing dividend record. Why would you say no to a interest rate of 8-10% and growing and a good chance of a higher price when the market recovers.

Q. Any recommendations?
A. Read Question on Friends' recommendations above. :-) I don't want to be cursed. The truth is I haven't done enough due-diligence on any of the stocks myself and don't feel comfortable recommending. And golden rule is even if I do, you will do all due-diligence before buying the stock.

Q. Portfolio recommendations
Stocks to Bonds: Between 75:25 in an under-priced market (like for example now) and 25:75 in a over-priced super-heated market (like 6 months ago). Do a re-adjustment of portfolio my looking at your portfolio at fixed intervals like once a month or once every 3 months. Of course, this needs to be done with your future cash needs in mind and should not be applied as is.

Q. Anything else?
A. If you hold a large portfolio of one share (like in the case of a Stock Option from your company that you want to either partially or fully sell at a certain price), look at the below post to see an opportunity to gain a good premium on the stock until it reaches that price. I will be trying it sometime soon .. so should be able to help you set it up in the near future (if you are interested).

Before you fall off to sleep reading this super-long post, let me end with a cliche I came across recently.

The No.1 Rule of Investing should be "I shall not lose my Capital".
Rule No.2 reads "I shall not forget Rule No. 1"

If you like this post, buy me a beer!

PS: A few tips from the master himself


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