Five Steps to Investing in Stock Market

Five Steps to Investing in Stock Market

Small retail Investors are less aware of the true picture before making investments. The idea to invest in Stock Market is generally given by close friend, relatives or some bank associate. Even after much convincing, some still see the Stock market as a real gamble and are unable to figure out the real reason why they should investment in stocks. These investors who are unsure of the opportunity in stock market generally end up investing in conventional instruments. Conventional Investments are fixed deposits (FDs) which assure you that the principal you invest would be safe. But one thing you are limiting is the upside of the returns you can earn with few simple considerations by investing in the stock market.

Limiting upside means that you are restricting the returns you can get on your investments. However, unlimited upside returns would consequentially bring a downside risk with it. The downside risk can be limited too while not restricting your upside or gains. But, the upside and downside scenario comes up much later first you need to follow certain basic steps to make the right investment.

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Right investment means choosing the right sector as well as the right company for our investment. It’s recommended that the sector you choose or the company within it should be able to give the results you are looking for. The vision of the company of investment should match the potential company you would like to invest in.

Figuring out the right investment and strategy comes up with these five steps to investing in stock market.

1. Objective of Investment

Most of the investments made by following the gut feeling end in a loss, so rather than going by the gut and making staggered purchases of stocks you should have an objective in mind.

Objective includes answers to question such as

  • Why am I investing?
  • Is there a specific need or just for Extra Income?
  • Are my cash position and liquid asset position sufficient for some debt repayment enough after making Investment?

Cash position and liquid asset position are to fulfill the short term liabilities. If your assets are less to pay near term liabilities then the result is unfavorable. You may end up taking a loan and paying interest or defaulting when your cash tied elsewhere. So before looking to invest in stocks make sure that near term liabilities will be paid by the remaining funds available after investment.

Though the questions stated above may seem very trivial but finding the real objective is what leads to right investments. When objectives are less clear we tend to buy without any direction which ultimately leads to the decrease in investment value and you start incurring losses. It is generally seen that once the value of investment decreases, an investor without objective wavers and tries to cover up the loss position. This covering up losses is a very risky move and the investor can ultimately loss his entire initial investment or more.

Thus, the objective lets you as an investor to mark out your investments and the ideal position you should take. Once the investor is clear there is less likelihood of you defaulting on your near term payments. The problem with most investors is that they do not make an assessment of their near term liabilities. This results in their early exit from their investment position to pay their creditors.

2. Time Horizon

Once you are clear with your objective, next figure out the time horizon. Time horizon is the period for investment before you would want the returns. A long term investor would have longer time horizon than a short term investor. Deciding the time horizon helps you to decide the Sectors to invest. Some Sectors may have longer lead times before returns or final project outcome is achieved. An investor with short time horizon should choose the industry based on the regular cycle of project returns in the industry.

Time Horizon ensures that the entry and exit is at the right time. What that means is that you who have made the investment don’t lose out because of late entry or early exit. Also, time horizon lets us figure out the right stocks based on the stage (Growth, Maturity or Decline) of the company or industry.

3. Risk Profile

Risk Profile essentially means the kind of risk you can bear. Risk profile is different for different investors. In general sense, “What is right for me may not be right for you”. The investor should be aware of their risk appetite and averseness. A risk-averse investor should essentially go for low risk and low returns stocks. This would mean investing in stocks which have low price fluctuations so the real returns are the dividend or bonus shares paid by the company annually. Risk taking investments would include investing in young growing companies which have the potential but may not be able to fare up well.

Risk profile makes you aware of the potential losses so that you are prepared. The preparedness can help you better understand your investment so that alternate investments can be figured out to cover up the loss position. Mostly, risk averse investors should see opportunities in companies which have come off well from their growth phase. For risk takers investing in growth may help achieve their high target returns. 

4. Top down Approach

Top down approach essentially means that you look at the stock based on the movements of the economy. This approach will help you to have right picking sectors which are pro-economy such as Infrastructure, means that sector which grow when the economy performs well and vice versa; economy-resistant means that the sector performs well irrespective of the economy such as consumer durable etc .

Thus, the Top-down Approach helps you select the right sector for your investment. Further, it lets you diversify your line of investments. In simple terms, a pro-economy investment can be diversified by economic cycle resistant stocks or vice versa. Diversification of investment reduces downside risk i.e. the maximum loss you can incur.

Top down approach when investing in other countries would begin by assessing the country risk profile for factors such as political stability, corporate governance practices and country law. These become essential since outside your home country the investment you make may give less leverage or chance to withdraw our investment or may result in losses in entire investment.

5. Bottom Up Approach

Finally, what we need is a Bottom Up approach. This essentially means that after figuring the sector we need to look up from the bottom.  It will ultimately help us figure out the right companies within our sector for investments. There can be a case that some companies may have better efficiencies and higher growth prospects as these are well managed. Starting right from the bottom helps to figure out whether the company we are investing will deliver the expected results as per the sector.

Bottom Up Approach lets us refrain from investing in company that are not well managed or operating inefficiently. These companies contribute less towards sector performance and may not enable us to achieve our investment objective.

Need for Diversification

Apart from the five steps to be followed, it is clear from the discussion that we need to diversify. In simple words, diversifying is a balancing act. In true essence it is meant for covering up the loss position.

Small investors rarely diversify since most of their stock market investments are impulse purchases or based on general opinions. Investment in single sector or industry may provide unprecedented returns but may lead to complete wiping-out of investment position in extreme market situations.

Just investing in different sectors may be less effective to diversify your investment. You need to further diversify within sector. If you are investing in a single company, you are again taking up a risky position. This may lead to potential losses even though the sector of our invested company fared well. There might be operational inefficiencies and management issues in a single company. So it is highly recommended to diversify at the micro-level as well and diversify your investment within sector.

After diversification at macro level- across sectors and micro-level within sector, you can be confident that your investment is safeguarded. But, one thing is important for diversifying that you look at the correlation between sectors. Correlation in general terms means how one stock in one sector changes when the other stock in other changes. A high degree of correlation between the sectors of your investment means that the downside risk cannot be written off. The movement of stocks in highly correlated sectors would move in the same direction. Thus, a loss in one sector investment is bound to result in a loss.

Investing in Fixed Income Securities

It is further recommended that rather than making all of your investment in equity shares, distribute a part of your investment in fixed income securities. Fixed income securities are bonds, preferred shares or any another instrument which pays a fixed amount of returns in form of coupons, dividends, interest etc. The use of fixed income securities gives an assurance of regular income. Also, the principal investment is safe and would be returned at maturity.

The returns in fixed income securities are generally less and may not be an attractive proposition for risk taking investor. However, the use of these securities does provide us the balancing act for our investment.

Last Word

“A good decision is based on knowledge and not on numbers”- Plato

This holds particularly true for investments in stock market. Just looking at recent numbers may not give an idea of the long term scenario for investment in a company. The decision has to be based on market information and our own analysis. For first time investor getting into the intricate details or complexities of Fundamental or Technical Analysis may be difficult. These investors have enough information at their disposal and can use the analysis from various platforms which they trust.

The steps shared here follow a simplistic approach that a less experienced small retail investor should ideally follow. There might be other approaches that a more experience investor can follow along with these steps. Taking these steps makes sure that your investment decision is sound and you have the understanding about your investment. Not knowing any bit about your investments and relying on the diligence of brokers may result in huge losses.

The article is written to help investors follow a stream lined approach before making an investment. This article does not advise or reject any approach. My idea in this article is to share the least minimum steps that investor should follow. Anyways the investors can further use Fundamental and Technical Analysis as per their understanding to get more out of the given market information.

Information about what you do is what makes you successful. Indeed the more informed you are, lesser are the chances of you losing out!

Author: Arpit Nikhra

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1 Response

  1. September 15, 2016

    […] Five Steps to Investing in Stock Market […]

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