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10 Rules for Successful Long-Term Investing

One of the simplest and most effective advice on investing comes from none other than Warren Buffett.

He once observed that the stock market is designed to transfer money from the active to the patient.

He is absolutely correct.

No matter how great the effort, success in investing doesn't come overnight. It is one of those things in life that takes time, discipline, and patience.

If you think you have a formula for making fast money from the stock market, you need to drop it right away.

The key to success in investing is adopting a long-term approach i.e. practicing long-term investing.

It is about following the right principles and having the right attitude.

Laid out below are 10 rules that we think will go a long way towards helping you achieve the right mind set and set you up on the path to long-term wealth creation.

  1. Invest, Don't Speculate: If you invest, you will get an investor's result. If you speculate you will get a speculator's result. What is the difference you may ask?

    An investment operation is one which upon thorough analysis, promises safety of principal and an adequate return.

    Operations not meeting these requirements are termed as speculative.

    Investment in a stock with a good financial track record and trading at decent valuations would be termed as investment.

    On the other hand, investing in a stock that's loss making or paying too high a price for a good quality stock will most likely qualify as a speculation.

    Please remember, investment and not speculation is the key to long-term investing.

    A fantastic example of what can be termed as investment and what can be called speculation is our recommendation on FMCG behemoth HUL back in 2010.

    While the stock is a hot property these days, it was more of an untouchable back then. No one was willing to invest in the stock as it had given almost zero returns over 10 years.

    Yes, that's correct. For 10 years HUL's share price had gone nowhere!

    However, what made us pull the trigger back then was our assumption that the stock had moved from being a speculation to more of an investment over these 10 years.

    The key deciding factor for us was the fact that we were getting the very same asset where we were more confident of the safety of the investor's principal.

    Well, just as the company embarked on its decade long journey of going nowhere, the company's price to earnings multiple was a lofty 40x. In other words, a lot of future expectations were built into the stock price.

    Naturally, the stock didn't go anywhere for a long period of time as those expectations hardly materialised.

    However, the things were different in 2010 when we set our eyes on it. The valuations had come down to a far more reasonable 24x which given the company's pedigree and its capital efficient nature, can easily be termed as attractive and with a greater assurance of a safety of principal.

    What is more, the stock now carried a dividend yield in the region of 3%, which further boosted our confidence.

    Therefore, despite reservations from some members of the team, we went ahead and recommended the stock to our subscribers.

    Our faith was vindicated when around 3 years later, we asked investors to exit at 2.5x the recommended price. In other words, a gain of 156%.

    It's a great example on how the same stock can be both an investment as well as a speculation depending on its valuations.

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  3. Know Your Type: If you are someone who's full time into long-term investing and are able to devote the time and effort needed, you should have a larger part of your portfolio in stocks as opposed to fixed deposits or bonds.

    Besides, you should have a slightly higher percentage of your stock allocation to mid and small caps as opposed to blue chips.

    On the other hand, if you are doing it as a part-time activity and are not able to devote the required time and effort, you should perhaps be equally invested between stocks and bonds.

    Besides, you should restrict your stock investments to those of blue chips and safe stocks and have less in mid and small caps.

  4. Be Mentally Prepared for a Big Disturbing Decline in Your Portfolio Every Few Years: Stock prices fluctuate a great deal on account of people's tendency to speculate.

    You should be prepared to see the market price of your portfolio down by 30% and even 40% in any given year.

    In fact, you can use these fluctuations to your advantage by buying stocks after the market has fallen a great deal and lighten up after they have gone up substantially.

    A great example of how we took advantage of these market fluctuations is the call we made in early 2014.

    At the start of the year, the national mood wasn't particularly cheerful. The government at the centre was drawing flak for its shoddy mismanagement of the economy and there was no respite in sight.

    Things weren't particularly great in the stock market either. The indices hadn't gone anywhere for 3 years post the December 2010 highs.

    And with elections looming, very few people were willing to stick their neck out and buy stocks.

    Our eyes were fixated on the long-term though.

    And from this vantage point, the stock markets looked quite attractive. Elections were a mere noise according to us.

    The real signal was whether the index was attractively priced from a long-term perspective. It certainly was.

    The Sensex was trading below its long term average price to earnings multiple of 18x and this meant double digit returns on the index from a 2-3 year perspective.

    Smallcaps were even more attractive. The Small Cap index hadn't recovered from the blow it took in the 2008 crisis and was still trading at half the level reached six years ago.

    Given this situation, we expected the markets to move up strongly over the next couple of years with small caps expected to do even better.

    Which is why we recommended our subscribers to take maximum exposure to stocks, a call that would have made them go laughing all the way to their banks as the index returned 43% in the following 12 months with many stocks going up significantly more.

    Some of the stocks that we recommended to our subscribers were up 545%, 170%, 170% and 150% in just twelve months.

    We believe it is a great case study on how to use the market fluctuations to one's advantage by being fearful when others are greedy and greedy when others are fearful.

  5. Know the Difference Between Timing and Pricing: There are two major ways of profiting from the fluctuations in the stock market. These are timing and pricing. By timing, we mean buying and selling based on the underlying trend in price. If the price is in an uptrend, an investor buys and the moment the price enters a downtrend, the investor sells.

    Pricing on the other hand is based on the concept of intrinsic value.

    Every stock has an intrinsic value based on its earnings capacity. Thus, one buys a stock only if it is trading at least a 20% discount to intrinsic value and sells if the stock has reached or is well above its intrinsic value.

    Needless to say, pricing is a more reliable and a logical way of investing and thus, key to success in long-term investing. Thus, knowing the difference between timing and pricing is of utmost importance.

  6. Always Look for a Margin of Safety in Valuations: The concept of margin of safety is central to the practice of long-term investing.

    Margin of safety does away with the need to make an accurate estimate of the future.

    Think of it this way, if you think a stock should be valued at Rs 100 based on its future profits then you should try to buy the stock at Rs 60 or lower.

    This ensures that your downside is protected even if future profits fall significantly below that of the past.

    The concept is so powerful that most successful value investors refuse to invest in a stock that does not have sufficient margin of safety.

    Our call on Tata Motors back in 2008 clearly spells out the benefits of using a big margin of safety in valuations.

    While the 2008 financial crisis may not have had a big impact on India's economy, its impact on the stock markets was massive. Just to put things in perspective, nearly thirteen lakh crore wealth was wiped out between December 2007 and December 2008, with the Sensex tanking by more than 50%.

    Clearly, it was the most pessimistic environment in years.

    Honestly speaking, we like a pessimistic environment. Not because we are pessimists but because we like the prices that pessimism produces.

    And this time was no different.

    Pessimism was indeed producing some really rock-bottom prices and providing a huge margin of safety in valuations.

    We saw pessimism being particularly overdone in the case of a large cap company that goes by the name of Tata Motors. Nearly 80% of the company's market cap was wiped away in the carnage.

    Of course, the company was going through challenging times. The burden of the US $ 3-billion debt raised for the JLR acquisition, a slowdown in the domestic auto industry and the onset of the global economic crisis made one wonder if the company had bitten more than it could chew.

    Ratings agency S&P then drew the final nail by downgrading the company's credit rating and also placing it on credit watch.

    Despite these challenges, we were confident Tata Motors could turn around. It had gone through similar tough times before and had emerged stronger from the experience every single time.

    Besides, it was already taking steps to get itself out of trouble. Cash management was being tightened, costs were being closely monitored and newer, more fuel-efficient models were being designed.

    Which is why when Mr. Market valued the company as though it was going to go bankrupt, we recommended our subscribers to enter the counter in December 2008 as the risk reward ratio had now become extremely favourable.

    There was a big fat margin of safety in valuations which meant that while any further downside was limited, the potential upside was huge.

    Turns out we were right as the stock turned into a huge 10-bagger over the next four years.

    Trading at an adjusted price of Rs 30 in December 2008, the stock went on to hit the 300 rupee mark in early 2012. This the magic of always insisting on a margin of safety in valuations.

  7. New: 5 Pandemic-Proof Smallcaps You Should Know About...

  8. Have a Sufficiently Diversified Portfolio: No matter how hard you try, you cannot have a 100% success rate in investing.

    In fact, legendary investor Peter Lynch is of the view that in this field even if you get 6 out of your 10 stocks right, you should consider it a job well done.

    Which is why, having a sufficiently diversified portfolio is very important. However, you should always guard against too much diversification.

    A good thumb rule to follow in our view is to have a minimum to 15 to a maximum of 30 stocks in one's portfolio.

  9. High Growth Companies Don't Always Make Good Investments: Investors have a tendency to invest in the fastest growing companies or the industry with the most growth potential.

    However, a fast growing company is rarely available at attractive valuations. Its price is usually bid up to high levels because other investors are also drawn towards it.

    Besides, it is difficult to predict whether the high growth will continue and for how long. Thus, unless such companies are available at attractive valuations or one is absolutely certain about the growth prospects, one should stay away from high growth stocks.

  10. Don't Ignore the Past Performance of a Company: Long-term investing is done based on how a company will perform in the future. However, this does not mean we should completely ignore its past.

    A company with a good historical performance has a better chance of doing well in the future than the one that has poor historical performance.

    So, it is better to focus one's attention and energy towards stocks that have recorded consistent profits in the past than the ones that have been frequently loss making.

  11. Do not pay too much Even for a Good Quality Stock: Investors are sticklers for quality and are willing to go to any extreme to invest in a quality stock. However, every stock, no matter how good, is attractive only at a certain valuation.

    Thus, if you pay too high a price, you are exposing yourself to a big loss in your investment or a scenario where the stock gives below par returns for many years at a stretch.

    It makes sense to always remember that price is what you pay, value is what you get.

  12. Take Care of the Downside and the Upside Will Take Care of Itself: Warren Buffett, one of the world's most successful investors, has two rules of investing.

    Rule # 1: Don't lose money and Rule # 2: Always remember rule number one.

    Well, this is how you should approach your investments as well.

    You should always strive to consider the downside if your thesis doesn't work out before taking into account the potential upside if it does.

    So, there you are...

    10 rules for long-term investing that are timeless and if followed, will lead to sound investment results.

Does long term investing really work?

It has been our observation that people who are more disciplined and have a better temperament usually end up having better long-term investment results than those who are very smart and have extensive knowledge of accounting, finance and even the underlying nature of the stock market.

Therefore, as long as one is not overpaying for any stock, maintaining adequate diversification, and staying out of highly speculative, loss making companies, there is no reason why one can't get very good results from long-term investing.

We believe there's a lot of hope for the average investor towards achieving market beating long-term results.

Happy Long-Term Investing!

Here are links to some insightful articles on long-term investing.

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