Only two factors decide return from an investment

Value = Cost + (Cost X Gain/Loss%)

Stock market is a bust place post Covid19. Many new investors are joining while old investors are adding more investment in hope of making good returns. Everyone will be following their own method, be it with help from friends & gossips, research help from advisors or free help from various online forums.

Despite all the differences in their methods, the investment return will, mathematically, depend on only two factors.

  • Cost of the Investment
  • Profit or Loss on the Investment

Everyone will agree to it. It not a big deal, we all know that. However as a general observation, all of us tend to focus on only one portion which is percentage gains or loss on that investment. It is possibly because whole financial world is obsessed with % movement of each script. The cost of investment is left to be decided by the individuals. This is where most retail investor do horribly wrong as they forget investment cost and focus almost entirely on changes of a stock going up or down.

In this article, we are trying to explain the importance of investment allocation. There is already enough analysis done on percentage gains or loss which shapes various investment strategies.

Typically, most retail investor follow a typical path. They start by doing one small investment into a stock after hearing great story from a friend. If lucky, they make some gains. Even 20% gain in few months for a beginner is too good as they compare it with FD returns which is single digit in one year. This tempts them to make more investments as they keep on hearing new stock ideas from friends or some random whatsapp group. Being risk averse, they generally put small amounts to each stock and try their luck. The idea is to make some gains, book that and move on to next such bet. Not all investments will grow at same pace, some may remain stuck or fall back. In that case investor goes on to hunt for new exciting idea and invest there. After a while, this leads to a situation where all the profitable stocks are booked while loss making stocks keeps on getting accumulated in hope of their revival in future. Naturally, portfolio continues to go deeper into the abyss and once bull market stops and bear market takes a firm grip, the loss making stocks goes so deep that they don’t have enough courage to book at a heavy loss. Again the theory of hope is at work as they think there is no point in selling now at so much loss. Also, somewhere Warren Buffet quotes comes to their rescue “Never loose money on a stock”

Warren Buffet may have no idea how investors will perceive it. While the best judge will be Warren Buffet to comment on his quote but we think what he meant was to buy stocks where the chances of loosing money is very small. That is why he puts so much emphasis on intrinsic value and entry point in a stock. It certainly does not mean that one should keep holding poor companies just on the basis of hope.

Hope & Stock Market does not gel very well in investor’s favor. There should be a proper investment reason behind a hope which you can explain to anyone within 2 minutes. If your investment logic is based on too many if & but then probably it is not a good enough logic. A great investment reason should be a no-brainer and simple enough to be convincing. Such a no-brainer idea even if proven partially wrong has a higher chances returning something if not big as compared to a logic based on many if & but.

Coming back to the main topic of this article, the two factors: Let’s discuss each factor at a time.

Profit or Loss on the investment

This is what is keeping most people busy. Not entirely wrong but let’s see what happens if someone only chase percentage returns.

One of the reason, retail investor succumb to this is due to their reliance on free tips or taking inputs from too many sources or advisories who keep on throwing new recommendations every month. Even if a person who is a serious investor but he subscribed to three monthly stock advisory service churning 3*12=36 stocks in a year. Plus his own investment on 10 stocks. By the end of the year, his portfolio will easily cross 50 stocks. For investors relying on free advice or whatsapp groups or internet forums will do ever worse. The chances of getting many multibaggers is pretty low in such cases. Law of average will ensure it never happens. Typically, there are 4 multibagger for every 100 stocks listed on the market. For an investor having 50 stocks, only 2 can potentially be multibaggers. But since cost of investment is too low as compared to overall portfolio size. This will hardly move the needle of overall portfolio. Not to forget that will rest 48 stocks will suck up the gains made by few good stocks. Overall, end result is often towards the negative side.

Let’s suppose your have got 50 stocks in an overall portfolio having total capital as ₹100. In a simple equal weight scenario, each stock has got ₹2 as the cost of investment. Let’s assume you are seeking multibagger returns, let’s say 5x in two years and it happens to one of your stocks. Your Value will be (₹2×5) = ₹10. On an overall portfolio of ₹100, this is hardly 10%. Hence you will need many such multibaggers to move your portfolio higher. Also with multibagger approach investor normally tend to incline towards smallcap or penny stocks. This further increases the risk of making losses for rest of the stocks.

More Risk ≠ More Returns

In the end typically, these approach often backfire rather than working for a retail investor. Most often investors following this strategy also book their profit while keep waiting for dud stocks to move up. This is plucking your flowers and watering the weeds. Naturally, your garden (portfolio) in sometime will become a giant mess of weeds with no flowers.

Cost of the Investment

Highly ignored. Most people take diversification too seriously and remain scared of putting large sums of money into few stocks. A retail investor should never invest in more than 15 stocks at any point in time. Best will be just 5. They are not running a mutual fund which is bound by regulations. Ideally, a retail investor should take feeds or stock ideas from many reliable channels or advisories, conduct their own diligence to comeup with super10 or super15 kind of a list. Invest heavily into the best ideas so once they give you a good return, portfolio decisively moves into positive zone.

Such an approach allows investor to put more money into top stocks. Taking an example, for the same ₹100 portfolio if an investor stick to only 10 stock (₹10 in each stock) and one of them becomes 5x. Portfolio value will move up by 50% (one multibagger alone adding ₹50). Since this list is highly selective, most stocks will be safer & quality stocks and chances of them eating away the profit made by one multibagger is lesser. Infact others can add up few more value from their side.

This portfolio will be clocking double digit returns as compared to earlier portfolio having 50 stocks. Not to mention this approach gives a peace of mind to investor since he has to take care of only 10 or 15 stocks at a time, relatively easier to manager than 50 stocks. On extreme case, one may go for just 5 stocks and if one of them become a multibagger, returns will be disproportionate.

In the end, the key message remains the same. For a retail investor they should run a focused portfolio. If this seems too tough then investor should stick to mutual funds instead of wasting time & money in running huge portfolio on their own. It is a choice one needs to make as early as possible so they can capture most of the bull market. You can do the maths on your own and simulate where your own portfolio is headed.

Value = Cost + (Cost X Gain/Loss%)

Remember cost of investment features two times in the overall equation while percentage returns just once.

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