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5 habits of highly effective investors - Views on News from Equitymaster
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  • Jun 18, 2007

    5 habits of highly effective investors

    The world of stocks is a highly dynamic one. One has to be constantly be on his/her toes in order to keep abreast with the latest developments taking place. To a layperson, it can be intimidating, with stock prices constantly changing every second. Of course, we have seen during the (in)famous market crashes that can happen when things do not go according to what the market expects. When unexpected events and their sudden impact on stock prices make even the most experienced among us quiver, imagine what the common investor must be thinking!

    However, we are of the belief that certain simple investing habits, if inculcated well into one's behaviour can make one's investing experience more comfortable and rewarding. In this article, we attempt to simplify matters for the common investor, by explaining some important habits that every investor must inculcate. A few of these habits are from one of the best self-help books called 'Seven Habits of Highly Effective People' by Stephen Covey, and have been modified to suit equity investment philosophy.

    In this write-up we shall restrict ourselves with stock market investing while keeping aside other assets like debt, gold and real estate aside for future discussions. As such, the term 'investing' used in this article will simply imply investing in the stock markets. Let us now take a look at some habits that characterises 'highly effective investors'.

    1. Begin with the end in mind: Investing, in its most broadest sense, is one of the most basic and important processes of preparing oneself for meeting future financial needs like child education and marriage and retirement. And stock market investing is no different. It has to be followed like a process with an aim of achieving your future financial needs. Started early, and done in a systematic manner, investing in good quality companies (ones with visionary managements, leadership in their industries, stocks cash generation capabilities and strong balance sheets) can help an investor generate good returns over a long-term.

    2. Think 'risk-risk': This is a modification of the 'Think win-win' habit as outlined by Stephen Covey. In making an investment decision, apart from returns, there is one more very important factor that should weigh heavy on your minds - risk. Simply defined, it is the uncertainty of happening/non-happening of a certain event(s) that is likely to affect future returns. A risk is generally attributed to external factors that create disturbance in the existing scheme of things. Some of these external factors are geo-political uncertainties (elections, terrorist attacks and wars), financial crisis and economic downturn.

      However, what stock buyers generally fail to understand is that, apart from these external factors, there is one very big 'risk-factor' that is very inherent (or internal) to them. This internal risk is that of 'indiscipline'. By indiscipline, we mean that stock buyers tend to forget the basic scruples of safe and sound investing, as they are then lured by the high probability of earning 'a big bang for their buck'. And this leads to even the best of investors putting their money into the worst of stocks believing that their invested company is the 'next big thing'. Ironically, as just these very times when stock buyers need to stick to the fundamentals of sound investing, they seem to forget the same (the fundamentals).

    3. Sharpen the saw: This is one of the most important habits of the ones mentioned in this write-up. 'Sharpening the saw' or educating oneself well about a potential investment before actually making the same is what determines whether or not the invested funds are destined to earn appropriate returns over the long-term. A good investment decision is made on the basis of a solid groundwork and research. Relying on 'hot tips' from brokers, friends and relatives, and anyone who wishes to give you some, might land you in trouble at more times than one.

    4. Understand your 'margin of safety': Understanding the concept of 'margin of safety', as promulgated by the legendary investor, Ben Graham, is very essential while investing in stock markets. For stocks, the margin of safety lies in an expected 'earning power' considerably above the interest rates on debt instruments. Simply calculated, earning power is equal to the reciprocal of price to earnings or P/E ratio. For example, a stock with a P/E ratio of 8 has an earning power of 1/8, or around 12%. In common parlance, this is often known as the 'earnings yield.'

      Considering the above example, assuming that the stock has an earning power of 12% and that interest rates on a 10-year bond is 8%, then the stock buyer earns an excess of 4% over bond, which is a margin in his favour. However, having a stock with a high margin of safety is no guarantee that the stock buyer would not face losses in the future. Businesses are subject to various internal and external risks, which may affect the earnings growth prospects of a company over the long-term. But if you have a portfolio of stocks selected with adequate margins of safety, you minimise your chances of losses over the long term.

    5. Be proactive: "You can either be proactive or reactive when it comes to how you act about certain things", says Covey. Being 'proactive' means taking responsibility for everything in life. When you are reactive, you blame other people and circumstances for obstacles or problems. Being proactive has been one of the most striking characteristics of successful long-term investors. By being proactive, an investor takes charge of his investments after he has made them, by reviewing his decisions at regular intervals. Blaming others for the 'tips' gone wrong might lead you nowhere.

    The list of habits mentioned above is not exhaustive. There are a few other characteristics that differentiate successful investors from the not so ones. Understanding businesses and financials of companies are other important links to a successful investment venture. The habits mentioned above have to be nurtured and honed over a period of time. We believe that these will help you in the pursuit of creating financial wealth for meeting your future financial needs and responsibilities.



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