Introduction: Why it is essential to know how to make money in the stock market? Because more people lose money in stocks than in any other investment option. Why? A trademark answer is, “stocks are risky”.
You must be fed up with this answer, right? You might be scratching your heads that if stock is risky, why do people still go for it? Because it can also generate high returns. How we can earn those high returns? By investing wisely in the stock market.
Investing wisely means buying the ‘right stocks’. How to buy the right stocks? By following a strategy. What is the strategy? This is what we will discuss in this article.
How much money can be made in the stock market?
There is an index fund called ‘HDFC Index Sensex’. In the last 15 years, this index fund has generated an annualised return of 12.9% p.a. What does it mean? We can decipher two things from this data:
- Why people lose money in stocks: On average, our index (Sensex) has grown at a rate close to 12.9% p.a. in last 15 years. Then why many people who invested in stocks directly (instead of an index), lost money? This is because they bought wrong stocks. What are wrong stock? Stocks of bad business, or of ones bought at a wrong price. How to deal with this ambiguity? We will know more about it in this article. Know more about best stocks here.
- How not to lose money in stocks: For risk averse people, who want to invest in stock market, they can simply buy an index fund and stay invested for 10-15 years. There is almost 99% chances that they will not make a loss. Know more about index funds. For people who are ready to take risk, their way of not losing money is to device a strategy for investing in stock market. Read more about stocks here.
So what you would like to do, buy index funds or direct stocks? People who chose index funds can make close to 12% p.a. in long term. This is a no-hassle investment.
But if you chose direct stocks, returns like 20-25% p.a. is possible. But direct stocks are also risky. If you do not invest in a right way, chances of losing money is almost certain.
In this article, we will see the strategy which can guide one to invest in direct stocks, by avoiding the risk of loss.
Process of Investing in Stock Market
Let it be stock market investing or any work in life, it is essential to first understand the overall ‘process’ of doing it. It is also important to keep it simple.
What this process does is, it defines the start and end, also identifies the intermediate steps. Following a process is an essential ingredient of success in life.
What should be the process of investing in stock market? These five steps:
- Research: No matter how confident we are feeling about a stock, it cannot be bought without researching. The idea is, even if Warren Buffett asks you to buy a stock, do not buy it without researching it yourself. Once you have researched, and is feeling confident about it, buy it. Read more about how to do stock research.
- Track Performance: One cannot buy stocks and forget about it. What shall be done is to track ones stock holdings. Why to track? This is done more to time the exit perfectly. If one is not tracking, he/she will not know when it is time to sell. Know about how to track stock’s performance.
- Goal Setting: When you will do stock research, you will get a feel of how much a stock is undervalued. Suppose a stock which generally trades at Rs.100, is now trading at Rs.65. Upon research you found that the strength of its business is intact. Hence you could estimate that in next 6 months, the stock price may rise to at least Rs.75. Hence you set a goal of Rs.75 in 6 months (15% up from current price). Check my stock watchlist for clarity stock’s target price.
- Selling: Like it is important to buy ‘right stocks’, it is equally important to sell those stocks at right time. How to know the right time? When a stock reaches its goal (like we saw above), it’s time for it to be sold. Do not become greedy for higher returns. Sell the stock holding as soon as it reached its goal. Read more about how to evaluate stock price.
- Reinvest: This is probably more important than all the above 4 steps combined. Just because you have sold the stock, it does not mean that you can spend this money. Make sure that this redeemed money goes back to Step one (research). Idea is to reinvest and buy another good undervalued stock. Reinvestment allows one to take advantage of the power of compounding returns.
DIY Learning of Stock Market
There is no other way to make money in stock market, one must first learn the basics. To learn the basics one cannot simply go to a training school and become an expert.
One must follow the DIY strategy (Do-It-Yourself) to learn stock investing. When it comes to stock investing, DIY is the only alternative. Why?
Because on one side we have people for whom share market is like an alien world. On the other side there are people who earn money in stocks as if it is a easy job.
There has always been this divide prevailing among people, and this divide is only growing. Why?
Because, people who do not understand shares, treat it as a roulette table. And people who know how to earn money from stock market, prefers to keep their knowledge as a secret.
So how a common man can learn and earn money in share market? The answer is simple…DIY (Do it yourself). How? This is where this article will prove its utility.
But there is another limitation. What? Be ready to give time, to learn & master stock market skills.
Allow me to share a strategy which can help (we common men) to make money in stock market.
1. Ask right questions about stocks.
This is one of the most important step in stock investing. What is stock investing for investors? “Buying good stocks at right price, and then holding it for long term“.
Hence, to earn money in stock market, a person needs to answer the following three questions:
- If this business is good: How to know if the business is good or not? One must do the fundamental analysis of its business. In fundamental analysis one evaluates size of its business, future growth prospects, financial health etc. Read more about fundamental analysis here.
- What is the right price to pay for this stock: What is right price? Price at which one can consider buying a stock. How to know about it? By checking its intrinsic value. If current price is below the intrinsic value, it is the right price to buy a stock. Read more about the concept of intrinsic value of stocks.
- How long should I hold it: Generally speaking, a stock must be held for long term (more than 3 years). Period. But there can be aberrations from this rule. This aberration will come into play when the goal is reaching earlier [Please see the process flow shown above]. Read more about how long is long term.
If one can answer the above 3 questions correctly, I will say that 99% job is done. The balance 1% is attributable to luck. To get a better feel of these three question, allow me to add more details here.
1.1 Buy stocks like an Investor, and not like a speculator
There are two types of people who buy/sell stocks – investors and speculators. More often than not, they contradict each other.
Investors may consider, a stock good. Speculator may not consider it good. Why this difference? Because investors and speculators have different “investment theories”.
Investors aims to make money with growth in business. Speculators aims to make money with growth in price of stock. But is it not the same thing? No it is not.
The difference lies in the way the two sees profits from stocks. Investors think, if the business grows, its stocks price will also move up with it. Speculators think, I do not care about the business, till its price is soaring the stock is ok for me.
Investors approach is more real and logical. While the speculator’s approach is more like gambling. To get more clarity, lets see how they see the following parameters of a stock:
- Market Price: Investor gives less importance to stock price than speculators. For speculators, stock price is everything. For investors, stock price is the last thing they see before buying stocks. Before price, an investor would look at its business. Read more about how to evaluate stock price.
- Underlying Business: Investors are more concerned about fundamental strengths of company. Once they are satisfied that the business is good, then they shift their focus to ‘market price’. For speculators, strength of underlying business is meaningless. They are only concerned about price momentum. Read more about how to know if a stock is worth buying.
- Holding Time: For traders, holding time is very short. They generally hold stocks in days. Their idea is to make money by selling stocks as soon as possible. For them several small-small gains builds their overall profit. For investors, holding time is long term. They generally hold stocks for a period more than 3 years.
1.2 Learn to do price valuation
When investors start selling their stocks, it is a buying-start time for speculators. Whenever the market becomes overvalued, investors sell stocks and book profits. This is the time when stock market is bullish. Indices like Sensex is only going up.
During this time speculators are trying to take advantage of the price momentum. While investors are thinking in terms of price valuation. Why?
Because in bullish market, stocks trade at overvalued price levels. This is an ideal time to book profits. How investors do price valuation? By estimating intrinsic value of stocks.
1.3 Practice long term investing…
Investor earn money in share market by holding on to their stocks for long term. How long, is long term holding for investors? Warren Buffett buys stocks to hold them forever.
I personally prefer holding on to my stock for at least 3 years. But for speculators, target is to make money by holding stocks for the shortest possible time. If they can book profits within a day, that is ideal.
Idea should be, buy such stocks which you can hold on to forever. Example: Microsoft, Apple, Google etc. Let these stocks remain idle in your investment portfolio for minimum 3 years.
After that, start tracking their performance. As soon as they reach the goal, sell it and book profits. Read about goal based investment strategy.
1.4 Do a detailed stock analysis
To earn money in stock market, it is important to know basic stock analysis techniques. Stocks needs to be evaluated in term of its fundamental strengths and also in terms of its price valuations.
People often skip the step of stock analysis, and straight away jump into buying stocks. But this is a wrong way of investing in shares.
It is almost impossible to earn money in share market like this.
Before committing to any stock, investors must ensure that if a stock is overvalued or undervalued. It is more likely to catch a fundamentally strong stock at undervalued price levels.
Lets see these key steps of investing in stock market:
- Step #1 – Check Price Trend: Open the price chart and see how the stock price has changed in last 6 months. Just note from where to where the price has moved (it has appreciated or depreciated). After looking at price chart, check the stock’s simple moving averages (SMA). Note the simple moving average (SMA) for last 3 months, 6 months, 9 months and 12 months. If SMA is showing a rising trend, this is a hint that the stock may be overvalued. Avoid such stocks. Target those stocks which is showing a falling price trend.
Report generated on my stock analysis worksheet.
- Step #2 – Check business fundamentals: What we have done in step #1 is, shortlisting of a stock whose price is falling. The next step is to identify its business fundamentals. How to do it? By checking the companies liquidity position, profitability, debt levels, growth prospects etc.
Report generated on my stock analysis worksheet.
- Step #3 – Check Price Valuation: In step 2 above what we have done is to evaluate if the business fundamentals of the stock is strong or not. There is one more check point. It is also essential to check if the price is right to buy or not. How to do it? By estimating its intrinsic value. One can also check price valuation by using financial ratios. Read more about financial ratios here.
Report generated on my stock analysis worksheet.
2. Buy stocks as if you are buying the whole business
How does it make the difference? Let’s take an example to understand the difference. We all know about the problem ‘Jet Airways’ is facing in recent days.
There are chances that the Jet Airways may also go down the Kingfisher Airlines way. But still there is a hope.
In this scenario suppose, your friend advice you to buy few stocks of Jet Airways (say worth Rs.5,000). Would you buy it?
You may take the risk. Why? Because if the things go well, you may see a windfall gain. If not, then the loss will only be of Rs.5,000.
Now suppose you are the owner of an another airline company. You are interested to take majority stake in Jet Airways. How would you go about it?
Would you buy the ownership just because your friend is saying to do so? Never. Instead, you will do your own detailed research and then take the next step. This is the right mindset.
This should be our approach even if we are going to buy only couple of stocks in any company. This type of mindset has capability to make millions – if you want to invest successfully in stock market. Why?
Because this approach will force you to follow all the steps specified in the point number one above (Ask right questions about stocks….).
What I have provided here in this blog post is something that I personally practice. This is the way I started to buy and sell stocks for myself.
I hope my suggestions are simple and understandable for you. A quick recap of what we discussed in this article about how to earn money in share market:
- Practising long term investing is key.
- Investing in stocks of fundamentally strong companies is a must.
- Develop thought process of an investor. Avoid speculating in stocks.
- Buy such stocks that you can hold on to, forever.
- Looking at short term price trends can give a good idea.
- Try estimating intrinsic value of stocks.
- Else, try the ratio analysis approach.
Have a happy investing.