Must-follow investment principles for smart investors

'Rome wasn't built in a day' - a phrase you've likely heard countless times. Legend says that it took an astounding 870 years to build Rome into one of the ancient world's greatest cities.

The same principle applies to stock investing as well. Becoming a successful stock investor isn't an overnight process. It takes years of practice to learn how to combine intuition with knowledge, trust your instincts and unearth opportunities others might not know of. Yet, to do so, having a sound framework from the get-go is important.

Thankfully, Benjamin Graham, the 'father of value investing,' has provided a roadmap to navigate this complex journey. His book, 'The Intelligent Investor', presented such a framework, which Jason Zweig further distilled in its later edition, making it more accessible to all.

Let's delve into the five principles of the framework in detail.

1) A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business with an underlying value that does not depend on its share price.

By investing in a stock, you own a piece of the underlying company's growth story. You become a part of the business's journey, where the ups and downs of the stock price are just one part of the adventure. Remember that the true value of a stock lies in the business's performance and not just its current share price.

Let's take the case of Tata Consultancy Services. In the last seven trading days (as of July 2, 2024), its share price has fluctuated by 0.22, 0.57, 0.44, 2.01, -0.73, 1.75 and 1.07 per cent. But this doesn't imply that the business's actual value has also fluctuated similarly. If anything, it would have remained constant over this short period.

2) The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists.

If you ask any seasoned investor to describe the nature of the stock market, they are likely to term it as 'cyclical'. Stock markets regularly oscillate between optimism and pessimism.

For instance, Sensex, which is one of India's leading indices, more than doubled from the lows of 1999 to reach its peak during the dot-com bubble in 2000. From there, it crashed nearly 60 per cent over the next two years.

A similar pattern was seen when the Sensex rose more than seven times from its lowest point in FY03 till FY08. However, in the next one year, it plunged by more than 60 per cent. The catalyst for these ebbs and flows could be interest rate changes, politics, technological breakthroughs, natural disasters, etc.

In such a scenario, an ordinary investor may have panicked and withdrawn their investments in haste. However, a smart investor would see beyond the market's mood swings and make decisions based on long-term value.

3) The future value of every investment is a function of its present price. The higher the price you pay, the lower your return will be.

Stock investing doesn't require complex mathematical calculations. All you need to know is the concept of 'compound interest', computed as:

FV = PV x (1 + r)^n

where
FV is the future value
PV is the present value
r is the rate of interest, and
n is the number of years

The formula clearly states that a lower present value will result in a higher rate of compounding for the same future value and number of years. However, there is a catch.

When it comes to investing, many tend to focus on the interest rate (r) rather than the time period (n). However, it's the 'n' that actually makes compounding possible in the first place. While a high 'r' is certainly desirable, it's important not to overlook the role of 'n ', as sustaining a decent return over a long period of time can work wonders for your money.

4) No matter how careful you are, the one risk no investor can ever eliminate is the risk of being wrong. Only by insisting on what Graham called the "margin of safety" - never overpaying, no matter how exciting an investment seems to be - can you minimise your odds of error.

All investors make mistakes. Yet, there are some investors who become successful while others don't.

The key difference between successful and not-so-successful investors is that the former's mistakes have little bearing on their portfolio's performance. This is because such investors understand the importance of a 'margin of safety'.

What do we mean by 'margin of safety'? Suppose a team of engineers and contractors are building a bridge that needs to support a total weight of 20,000 kilograms. They are not going to design it to handle the exact weight. Instead, they will build the bridge such that it can support 25,000 kilograms or even 30,000 kilograms. In this case, this extra weight or capacity is the margin of safety. It ensures that the bridge remains safe and secure if there's a sudden increase in load.

Similarly, you should look for a margin of safety when investing in stocks. A company might seem worth Rs 100 per share based on its fundamentals. Depending on various factors, you might want to buy it at Rs 60 or Rs 80. The discounted price provides a buffer against errors in your analysis or unexpected changes in the market or the business.

5) The secret to your financial success is inside yourself... By developing your discipline and courage, you can refuse to let other people's mood swings govern your financial destiny.

In the world of investing, your greatest adversary is often yourself. This is because the stock market is a culmination of the opinions and sentiments of all market participants. It demands a significant amount of self-discipline and courage to remain composed and not be swayed by others' mood swings. Naturally, such a skill requires years of patience and perseverance to master.

If you recall, the stock markets tanked when governments worldwide announced country-wide lockdowns at the onset of the Covid-19 pandemic. Many market participants were happy to sell their investments and wait on the sidelines. However, investors who bought shares in the early months of the pandemic (March-May 2020) enjoyed (or are currently enjoying) extraordinary returns in the next few years.

Your takeaway

Each of the above principles is interconnected. Together, they provide a logical and sound framework for building lasting success in the stock market.

Also read: Seven investing sins

This article was originally published on July 03, 2024.