Over time, stocks have showcased an impressive track record of delivering higher returns compared to other assets such as bonds, bank deposits, gold, and real estate. Take, for instance, the Nifty 500 index, representing the top 500 listed companies in India, which has demonstrated an annual return of 12.48 percent over the last ten years. It’s important to note that, while stocks come with risks, investing wisely and conducting thorough research can lead to substantial gains and fruitful financial opportunities. It’s all about making informed decisions and staying committed to long-term investments.
To be a successful investor, your temperament is more important than your intelligence. It’s about having the discipline to follow an investment strategy and not letting your emotions cloud your decision-making. Investing can be a highly emotional endeavor, especially during periods of market volatility. It’s natural to feel a sense of fear or excitement when making investment decisions. However, a successful investor understands the importance of keeping emotions in check and sticking to a well-thought-out plan.
One common mistake many investors make is trying to time the market. They attempt to buy low and sell high based on short-term fluctuations in stock prices. This approach is often driven by emotions and can lead to poor investment results. Instead, a successful investor focuses on long-term goals and maintains a disciplined investment strategy.
Discipline is key in investing. It means staying committed to your investment plan even when faced with market downturns or unexpected events. It means having the patience to ride out temporary fluctuations and not succumbing to knee-jerk reactions. By staying disciplined, investors can avoid making impulsive decisions that may harm their long-term financial goals.
Another vital aspect of successful investing is avoiding herd mentality. It is common for investors to get swayed by the opinions and actions of others, especially during times of market frenzy. However, following the crowd blindly can be detrimental. It is essential to conduct thorough research, seek expert advice, and make informed decisions based on your own financial goals and risk tolerance.
Moreover, a successful investor understands the importance of diversification. By spreading out investments across different asset classes, industries, and geographies, one can minimize risk and potentially enhance returns. Diversification allows investors to mitigate the impact of any specific investment performing poorly, as the overall portfolio is not overly reliant on any single investment.
Besides, staying informed and continuously educating oneself about the financial markets is crucial for success as an investor. This means keeping up with news, understanding economic trends, and monitoring the performance of investments. By staying knowledgeable, investors can make informed decisions and adapt their investment strategy as needed.
In this post, I will reveal a comprehensive 7-step process to confidently create and manage a stock portfolio that is destined to deliver exceptional long-term returns. The first 5 steps are dedicated to the construction of the portfolio, while the final 2 steps provide invaluable guidance on efficient portfolio management. Let’s dive in!
BUILDING A STOCK PORTFOLIO
The first stage of the process is building a stock portfolio, and this involves five steps. They are, deciding on:
- the investment corpus,
- the time frame to fully invest the corpus,
- maximum exposure to a single stock,
- maximum exposure to a single sector, and
- the most important step, choosing the right stocks for your portfolio.
1) Decide your Investment Corpus
As stocks can be risky, it is recommended to have a lower proportion of stocks in your investment portfolio compared to safer options like bonds, insurance, or bank deposits. The exact proportion depends on your risk tolerance. Generally, younger people can take more risks, while older people should be more cautious.
Note: Instead of directly investing in stocks, you can indirectly invest in them through mutual funds, equity-linked insurance products, alternate investment funds (AIFs), or portfolio management services (PMS).
You don’t need to have the entire investment amount ready from the beginning. You can start with an initial amount and gradually contribute more over a period of two years. For example, if you have a total investment goal of ₹5 lakhs, you can start with ₹2 lakhs and add the remaining ₹3 lakhs in installments over the two-year period.
2) Decide your Investment Time Frame
The next step is to pick a time frame to invest your money. It’s not a good idea to invest all of it at once. I recommend investing over a 2- to 3-year period to build your portfolio.
This step can be tricky. When stock prices are high and people are optimistic, they tend to invest aggressively. But when prices are low and people feel pessimistic, they hesitate to invest.
It’s not to your advantage to invest everything too quickly or wait too long. That’s why I suggest a 2 to 3-year time frame. Take your time, but not too much.
3) Decide the maximum exposure to a single stock
Risks that are specific to a particular stock are known as unsystematic risks. These could be poor earnings announcements, diminishing prospects, deterioration in fundamentals, accounting or financial irregularities, or poor strategic management decisions.
The normative approach to mitigate unsystematic risk is to limit your portfolio’s exposure to any single stock. You decide the maximum percentage of your portfolio that you will invest in a single stock. I suggest, from a cost perspective, a maximum exposure of 5 percent of your portfolio to a single stock. This is on a cost basis. It is a completely different situation if the stock triples or quadruples in price since your investment and thus occupies, say, 15 percent or 20 percent of your portfolio.
4) Decide the maximum exposure to a single sector
This step is a lot like the previous one. In this step, you insulate your portfolio from risks particular to any single sector by limiting your exposure to that sector within the portfolio.
During economic expansion, cyclical stocks will exhibit strong earnings growth and margin expansion, which leads to a sharp rise in their stock prices. But during the economic slowdown, demand, earnings, and margins contract for these stocks, leading to poor stock performance.
Your portfolio will see massive underperformance during an economic slowdown or recession if your portfolio is heavily tilted in favour of cyclical stocks. So, it is appropriate to have an optimal mix of cyclical and non-cyclical stocks within your equity portfolio to help you weather the economic cycles efficiently.
Note: Cyclical stocks are stocks of companies with products or services whose demand is closely correlated to the economy. E.g., automobiles, auto-ancillaries, restaurants, hotels, basic materials, etc. For non-cyclical stocks, the demand remains steady whether the economy is in expansion, slowdown, or recession. Consumers are less inclined to cut spending on these companies’ products during a slowdown. E.g., pharmaceuticals, power producers, consumer staples, etc.
5) Choosing the right stock for your portfolio
Undoubtedly, this is the most crucial step in the whole process. It involves finding good stocks that have the potential for high returns after considering the risks. In today’s fast-paced financial market, making informed investment decisions requires careful analysis and evaluation of various factors.
Analyzing and valuing companies requires some level of understanding and expertise from the investor. It is essential to delve into the company’s business model, industry dynamics, competitive advantage, and future prospects. Evaluating financial statements, such as balance sheets, income statements, and cash flow statements, provides insights into the company’s financial health and performance.
A thorough assessment of a company’s management team and their track record is also crucial. Understanding their strategic vision, execution capabilities, and track record of creating value for shareholders can give investors confidence in the company’s long-term prospects.
However, it’s important to note that individual investors may not always have the necessary time or expertise to conduct such in-depth analysis. In such cases, seeking assistance from an investment expert or financial advisor can be a wise decision. These professionals have extensive knowledge and experience in evaluating stocks and can provide valuable insights and recommendations based on their expertise.
Analyzing and valuing companies is an integral part of the investment process that requires time, expertise, and diligence. While it may seem daunting at first, investors can equip themselves with the necessary knowledge or seek assistance from professionals to make informed investment decisions and navigate the ever-changing stock market landscape.
MANAGING YOUR STOCK PORTFOLIO
Once you have built your stock portfolio don’t tamper with it too much. Making frequent changes to the portfolio will not do much good other than undermine your portfolio’s performance. I don’t mean that you keep the portfolio strictly untouched once fully invested. Necessary changes must be made; only frequent, unnecessary shuffling influenced by emotions or noise (non-relevant, useless information) is to be avoided.
The next two steps aid in managing your stock portfolio efficiently.
6) Keep Track of the Fundamentals
You should always stay updated on the fundamentals of your portfolio’s constituent stocks. Try to answer the following questions:
- Has there been any significant change in the company’s business model?
- Does the company have a robust balance sheet; has it recently taken on significantly large debt?
- What is the revenue, earnings, and dividends growth rate and trend?
- Is the return on capital and margins stable, expanding, or declining?
- Is the stock undervalued, fairly valued, or overvalued?
- What is the management’s strategy for growth and profitability?
You can add your questions. The primary objective of these questions is to ensure that the fundamental factors that gave the stock a high prospective return when you first invested in the stock are still intact.
If the fundamentals are strong, you can hold on to the stock. If the fundamentals are strong and the stock is undervalued, you could buy more. If the fundamentals are strong, but the stock is overvalued which means it has a low prospective return, you may reduce your holding in the stock. If there are signs of deterioration in fundamentals, then better sell and exit the stock.
7) Measure the Portfolio Performance
We build and manage a stock portfolio to achieve superior investment returns and that requires you to measure the portfolio’s performance to know whether it is fulfilling your investment objective. Several factors can influence a stock’s price in the short term. But in the long term, the fundamentals dominate. Don’t give much importance to short-term performance because it doesn’t matter. I recommend measuring the portfolio’s return over a 3-year or 5-year period.
Usually, portfolio performance is evaluated in comparison to a stock index like Sensex or Nifty 50. The selected index is called the portfolio’s benchmark index. A portfolio is said to have outperformed if the portfolio return exceeds the return of its benchmark index. Similarly, the portfolio is said to have underperformed if the portfolio return is less than the return of the benchmark index.
If your portfolio is underperforming, check the return of individual constituent stocks to identify stocks that are contributing to the underperformance. Eliminate laggards that are a drag on your portfolio.
Managing your stock portfolio has a few similarities with physical exercise. One similarity is that, in both cases, you should stick to the routine regularly to see the benefits. The second similarity is that, in both cases, the benefits become visible only after some time. The third similarity is that, even though both involve simple, easy-to-understand activities, many fail at them because of the doer’s lack of discipline to follow through.
I strongly recommend that you fulfill the following conditions before embarking on building a stock portfolio.
- You will not use the money you may need in the next five years to build the stock portfolio.
- You are mentally prepared to see stocks within your portfolio decline by 50 – 75 percent in value.
INVESTOR PSYCHOLOGY
These 7 steps, when strictly adhered, to will help you achieve superior returns consistently from the stock market at minimum risk. But the hard part is execution. Many fail at investing due to their lack of discipline to stick to a process.
They buy at the peak and sell at the bottom of the market. They held on to losers, even though there was clear evidence of deterioration in the stock’s fundamentals for some time. Why? Because selling would prove them wrong, and they are unwilling to easily agree to that. At the same time, they sell their winners too early because they fear losing their gains.
Patience is the most cited essential trait for successful investing. And emotions are the most cited obstacle to successful investing. Many know that they must stay invested for the long term to achieve superior returns, but they fail to do so. Why?
One reason is short-term underperformance leading to despair. When other stocks are rising while his/her stock remains stagnant or even declines, that may cause him/her to doubt the reasoning behind their decision. Then there is the thrill-seeking tendency; the thrill one gets by constantly getting in and out of stocks.
During periods of panic, fear overwhelms him, causing him to sell out, unfortunately, at throwaway prices. And during periods of euphoria, greed overwhelms him and sways him to buy popular stocks trading at unsustainably high prices.
Investors face a challenge with noise in the markets. Noise refers to irrelevant and useless information that bombards them through news and social media. This leads to a dilemma, as they need information to make good investment decisions, but most of the information they receive is noise. Noise misleads and hinders effective decision-making.
To tackle this, investors can replace spontaneous decision-making driven by noise with a slower and more thoughtful approach. When tempted to make quick decisions based on market forces and noise, it’s important to slow down, stay calm, and make a conscious effort to engage in reflective decision-making.
CONCLUSION
I don’t claim these seven steps are the only path to achieving superior returns from the stock market. Neither will I claim they are the best. There are hundreds of paths through which you can achieve your investment goals, just like there are hundreds of paths to the top of a mountain. You need to find the path that is ideal for you.
Wealth is not the most important thing in life. But it is a strong contender after health and relationships. I suggest you give it its due importance and the sooner you do that, the better. Most people realize the value of health, wealth, or relationships very late in life, but by then they have lost the most important resource they had – Time. I hope that doesn’t happen to you.
AMN CAPITAL 
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