What do we understand by long term investing? Obviously it refers to a longer period of say 6-8 years. But that is not all. Long term investing is based on some key assumptions. When we say hold for the long term, what do investors interpret from the same?
The first question you ask when it comes to long term investing is whether this is the right stock and this is right time. There are no simple answers to this question. If one goes by valuations, we are definitely above long term average valuations. It has now been empirically proven that long term investing is what works in the case of equities. But long term investing is not just about holding on to your stocks. There are certain assumptions underlying long term investing that investors need to be conscious about. There are 4 basis philosophies that every long term investor needs to follow for long term investing. This will help you to understand what long term investing is all about.
Limit the number of stocks you buy; be selective.
That is where you start; keeping a tab on the number of stocks so that you can effectively track them. You don’t want to create a bulky portfolio of too many stocks. While there is no hard and fast rule about the number of stocks you should hold, your core investment portfolio should not cover more than 18 to 20 stocks. There are two reasons for that. Firstly, your portfolio is something you should be able to monitor consistently and in detail. Monitoring your portfolio is all about monitoring industry trends, global macros, news, F&O data, volume shifts, advance declines, quarterly results, order book position etc. This kind of detailed monitoring is well-nigh impossible if your portfolio is too bulky.
Your core portfolio must be able to off you in-built diversification. According to empirical studies, 15-18 stocks in any portfolio can realize the full potential of diversification. Anything beyond that number only leads to substitution of risk and not reduction of risk. Hence, the smaller your core portfolio the better because adding stocks beyond a point don’t reduce your risk!
The next step to investing is to be conservative and avoid overtrading…
A long term portfolio has to be necessarily long term and you can get too aggressive about churning it. Avoid getting in and out of stocks too often. Your core investment portfolio must change only if you perceive a serious change in the fortunes of the company due to some emerging trend that could disrupt the performance of the company. When you overtrade you need to worry about the impact cost, trading costs, regulatory costs as well as taxes. Also you are missing out on natural wealth creation when you jump in and out of stocks. As a smart long term investor you surely wan to minimize each of these costs to the extent possible since these small items can compound over a longer time frame.
Investing is all about benchmarking against a solid index of performance…
At the end of the day, the long term is nothing but a compilation of a series of short term performances. Long term does not mean that you put money and forget about it. It is very critical that your portfolio is at least at par with the index and occasionally better than the benchmark indices. If you are at par with the indices for too long, there is something wrong with your portfolio. You are just doing as good as an index fund so there is no value addition from your side in terms of strategy. An index fund could have done this job as effectively, then why the risk of equities? If your portfolio is consistently underperforming the index do a rigorous review of the laggards and understand why the stock price is not reflecting your fundamental beliefs. Occasional underperformance is part of the game in a long term portfolio. But if your portfolio is lagging continuously, then alarm bells must start ringing. You must move in quickly to identify the core of the problem and try to look at measures to overcome the same.
Long term investing is all about managing your risk…
In his landmark book, “Against the Gods”, Bernstein had rightly pointed that the reason financial markets developed in the 20th century is due to a better understanding of risk; both academically and practically. There are 2 sides to the investment game viz. return and risk. If you are earning good returns on your portfolio but the risk of your portfolio is too high, you have to change course. Your portfolio is just too vulnerable to external shocks. Always evaluate your portfolio returns on a risk-adjusted basis and ensure that you are constantly evaluating whether there are any disasters waiting to happen in your portfolio. Keep asking the following questions at all points of time. Are there are companies in your portfolio which are highly leveraged? Are there companies whose business models are likely to be hit by disruptions? Are there companies in your portfolio which are commodity based and hence dependent on the super cycle? Are there companies that are losing out to competition both in terms of market share and profit margins? Nokia is a case in point globally. Each of these points is a risk highlighter and must be acted upon immediately.
What we have given above is not a framework for investing. But, an understanding of these 4 philosophies will help you get more value from your long term investment and, of course, generate wealth in the long term!