Finance 101: Stock Trading & Investing secrets

There is a lot of difference between Stock Trading and Investing. Traders make more frequent stock trades hoping for higher returns than that is possible with a buy-hold Investing strategy. On the other hand, Investors target long-term wealth generation by the compounding of returns, reinvestment of dividends, gaining stock bonuses & splits, etc. While in stock trading you would rely on sound money management, technical analysis, and a stop loss to hedge risk, Investors rely more on fundamental analysis and diversification of their stock portfolio. My belief is that you need to be a good Investor first before you engage in Stock Trading to mitigate your risks. 

As a multibagger stocks blog, the concepts here are meant for Investors. But traders too can immensely benefit from the ideas mentioned below on how to buy stocks. 

Stock Trading Strategy to sleep better at night

A lot of retail Investors or Traders I know, have a very Mark Cuban approach when it comes to keeping a major percentage of assets in cash. The billionaire investor likes to keep 50% of his portfolio in cash which gives him the liquidity to chase new investments and sleep better at night. He likes to profit from a sudden dip in asset value usually by making short-term trades. By keeping liquidity, a lot of my friends seem quite happy with the profits they make in short-term trades. But as an investor looking to make bigger returns in the stock markets, I would have to assume more risk. Instead of learning how to trade stocks, I would have to learn how to invest in stocks. 

Multibagger Ideas: How to invest in stocks?

If I had a 10-year time frame to build up my stock portfolio, I would still aim for the rare dips in Blue Chip stocks like Mark Cuban. But I would also like to behave more like an investor and aim to remain invested to reinvest dividends and receive all the stock bonuses and splits. I would also hope to remain invested every time the company undergoes a stock buyback or attracts an ETF or Mutual Fund investment. With time, my investments would give me increasingly compounded returns. Multibaggers is a term that may refer to a stock that gives multiple returns over its cost. To “bag a Multibagger stock“, you will most probably have to stay invested for a long period. 

Maybe if I had a net worth of 3.3 Billion USD like Mark Cuban, I would be more risk averse. But for most investors out there reading this, we all have a long way to go. If we are seeking out big returns in the stock markets, we have to stay in the game for the long run. By keeping a major chunk of your wealth in cash, you may miss those few days in a year when stocks rise up to make gains for the entire year. As a retail investor, you really don’t have access to the valuable research & analysis that will enable you to efficiently time the markets every time.

Trading vs Investment: Which is better?

If you collect the data of daily returns for a year and sort them. You would find that most of the gains happen around unexpected brief periods of time. The stock could be going nowhere the whole year but may suddenly rise up one week. Timing the markets with precision can be a difficult task. It is not easy to find those multi-bagger picks at the right moment and then be able to sell them later at the right optimal price.  Hence an Investment approach is more viable to ensure consistent positive returns.

A lot of my investments tanked as soon as I bought those shares. But as I had the patience to wait out the volatility, most of them have risen considerably in the medium to long term. Investing lets you capitalize on the compounding effect of returns to build wealth. Hence even if you cannot find the best stocks to trade, you can always find good stocks to invest in. 

Stock trading involves frequent transaction charges and short-term capital gains tax. Over the long term, this can have a hugely detrimental effect on your wealth generation. There are a lot of Billionaire Investors around but lesser such successful traders. Hence, Stock Trading for Dummies is appropriate when you should be trying to invest in stocks like a pro. To learn how to trade stocks online you should first learn how to invest in stocks.

How to Invest in the Stock Market like a Pro

Hence my approach to investing in the stock markets is to stay long in a diversified portfolio of fundamentally strong companies with sound business growth ahead. I do not cash in my portfolio even if I make some decent returns. As long as the fundamentals have not changed, I do not see any reason to sell my investments. I believe that one can never time the market precisely but one can identify the potential for long-term growth in companies.

A Blue Chip stock with sound fundamentals, trading at a PE much lower than historical PE should grab some attention. Further, the drop in share price can be further analyzed to identify the Systematic and Idiosyncratic Risks. If it’s a Systematic risk affecting the overall markets or industry, then investment can be a safer bet as the fall has lesser to do with idiosyncratic reasons like the management of the company. Moreover, with cyclical trends, this could be nothing more than a wonderful opportunity to enter long.

As an MSc Finance graduate and a former Investment Consulting Analyst, I would like to share a few simple concepts and tips that will make you Invest in stocks like a Pro. These ideas have helped me identify a few potential Multibagger stocks in 2016. Stocks like Emmbi Industries, Vakrangee, Cairn India, Motherson Sumi, Associated Alcohol, etc have zoomed over 100% returns in a year. Alternatively, more stable Blue chip stocks picked at the right moment have risen up huge. 

Multibagger Stock Investing Idea 1: Dividend Discount Model

I seek out dividends paid with credible payout ratios that enable future growth. Apart from consistently increasing dividend flows over a period of time, I would prefer the payout ratios to remain steady. With higher dividend payout ratios the company may pay the investors most of the profits while reinvesting lesser. The Dividend Discount Model (DDM) basically values a stock by predicting future dividends and discounting them to present value. In other words, if you were to buy a dividend-paying stock forever how much dividends discounted to present value would you make?

Hence the Dividend Discount Model (DDM) would value stock as {D*(1+g)}/(k-g) , where D is the most recent paid dividend, g is the dividend growth rate and k is the discount rate. No use in mentioning a formula without describing its derivation. So let us get straight to the Math.

Multibagger Math: Derivation of the Dividend Discount Model

The Dividend Discount Model is also referred to as the Gordon Growth Model or the Dividend Growth Model. The growth in dividends is a crucial metric for investors seeking to make big money in the stock markets.

Suppose the Company has paid a dividend D, so the next dividend can be calculated as

⇒{D*(1+g)/(1+k)}.

As the Dividend would grow by (1+g) in a year and would be then discounted by (1+k) for year 1.

The second dividend would be ⇒ {D(1+g)²/(1+k)²}, the third would be ⇒{D(1+g)³/(1+k)³}and the dividend after n years would be ⇒ {D*(1+g)^n/(1+k)^n}.

Anyone good with Math would see that the sum of the dividends is a sum of a geometric infinite series.

Moreover the common ratio ‘r’ in the Geometric series a1+a1r+a1r2+a1r3+….,

Or ‘(1+g)/(1+k)’ in our dividend series ⇒{D(1+g)/(1+k)}+ {D(1+g)2/(1+k)2}+{D*(1+g)3/(1+k)3}+…

Is also bounded by -1<r<1.

The formula for the sum of such a Geometric infinite series with -1<r<1 is

⇒ a/(1-r).

Hence, applying this formula to our Dividend series, you get:

⇒[{D*(1+g)/(1+k)}/ {1-(1+g)/(1+k)}].

By simplifying the above sum of infinite dividends, you will get ⇒ [{D*(1+g)}/ {k-g)}]

The dividend Valuation Model is a simple valuation tool for your stocks

If the stock is trading below this value ⇒ [{D*(1+g)}/ {k-g)}], then it is undervalued, while if it trades above it is overvalued.

A lot of Penny stocks do not have a steady dividend history. Hence the only Penny stocks to buy would be those that ensure steadily growing dividend payments. 

So are you willing to pay your mutual fund manager to do the above calculation for you or would you rather do it yourself?

Either case, you would want to be invested if you can vision your incoming growing dividend cash flows. The Dividend Discount Model is crucial to identify future multi-bagger stocks.

Multibagger Stock Investing Idea 2: Yield Curves

A Yield Curve is basically a plot of interest rates of bonds with similar credit quality and different maturity dates.  Macroeconomic study and understanding the Business Cycles is crucial in Equity investing. Even if you only invest in equity, you should understand the Bond markets. By understanding the yield curve, I can forecast inflation and future economic activity and make adjustments to an equity portfolio accordingly. Understanding the yield curve can help you identify which stocks to invest in. 

Normal & Inverted Yield Curves: Recession Indicators

A Normal Yield Curve is one where the short-term maturity bonds have lower yields in comparison to the long-term maturity bonds to compensate for term risk or the risk associated with time. Normal Yield curves signify periods of economic expansion as interest rates are only expected to rise ahead to manage inflation.

Alternatively, you have an Inverted Yield Curve when an economic recession is expected.  Hence, short-term rates are bound to be reduced to foster economic activity.

Hence, by studying the yield curves you can understand if a recession is expected.  Accordingly, you can invest in non-cyclical stocks over the cyclical stocks that are suited for periods of expansion. In other words, Invest in stocks of products and services that everyone needs like Utilities, Medicines, Consumer Staples, etc to be safe when you have Inverted yield curves. When you have a Normal yield curve you could profit more by investing in Car Manufactures, Airlines, Hotels, etc.

By investing in the long term, I hope to compound my gains exponentially. By understanding the yield curves, I can more accurately hedge these risks by timing the market better.

Multibagger Stock Investing Idea 3: Understanding Financial Risk and using the Value at Risk

Financial Risk is usually categorized as Market Risk, Credit Risk, Liquidity Risk, Operational Risk etc.  

Financial Risk 1: Market Risk

Market Risk can be defined as the risk arising from the changes in the value of tradable assets. It can be further categorized as Equity Risk, Interest Rate Risk, Currency Risk, and Commodity Risk. To optimize the risk management of your equity portfolio for a given time period, you principally focus on the Market Risk using a metric like Value-at-Risk (VAR).

Financial Risk 2: Credit Risk

Credit Risk is the risk of loss from the failure of a counterparty to pay an obligation. This is useful when you study the fundamentals of a company. By examining the Financial Statements and the credit ratings directly, you can clearly understand how much the company spends on interest expenses, its ability to meet short-term and long-term loan obligations, etc. In a low credit rating company, a chunk of the revenues may be spent on financing expenses. Why would you want to invest in such a debt-ridden company if there is a more competitive peer company that enjoys cheaper financing? Hence, examining the credit ratings of companies can help you find the best stocks to invest in. 

Financial Risk 3: Liquidity Risk

Liquidity Risk refers to the risk of liquidating an asset with little price impact or even the risk arising from the inability to meet a payment obligation. The Indian currency demonetization in 2016 seemed to have completely ignored the Liquidity risk arising from the decision.

Multibagger Financial Risk Metric: Value at Risk (VaR)

The Value at Risk (VAR) is a popular Market Risk measure that aims to indicate how bad things can get.

For a given portfolio, the Value-at-Risk(VAR) is defined as the value that the Portfolio can lose within a time period (t) with a certain probability ( ) or confidence interval. For example, if the probability of having a portfolio of 100,000 $ decrease by 20% or more within a year is less than 10%, then the VAR is equal to 20,000 $ with =0.1, t=1 year.

Expressed in Dollar terms rather than percentage terms, the VaR is a useful Market Risk indicator under normal market conditions. I say normal market conditions because the VaR may tell you how much wealth you can lose with a certain probability. However, it does not tell you much about the bigger possible losses under extreme conditions. The VAR does tell you that the magnitude of losses cannot be bigger than a certain dollar value for a certain confidence interval. But it does not tell you the magnitude of losses when it exceeds the VAR value.

Extra Advanced Stock Trading Topic only for Finance nerds

The Expected Shortfall or the average VaR helps paint a better picture. The expected shortfall is more reflective of the bigger loses under extreme conditions. Moreover, Expected Shortfall satisfies the condition of subadditivity. In other words, as a risk measure, the risk of holding two assets in a portfolio is lesser than the sum of the individual risks of holding the two assets, i.e.  (x+y) = (x) + (y).

How to calculate Value at Risk for your portfolio?

As a retail investor, there are many ways to calculate the portfolio VAR. In the simplest of cases, you can sort historical returns for the past 100 days of an asset. The VaR with 95% confidence interval is the 5th largest loss. This is obviously a very simple model and an even better method for calculating the historical mean returns and standard deviation and forecasting the returns on a normal curve to find the VaR. The model assumes the stock returns to be normally distributed and is called the Variance-Covariance method.  

Alternatively, you can try the more complex Monte Carlo simulation method to make a more accurate VaR calculation. The Bottom line about using the VaR is that it not only helps you to choose ideal entry and exit points in a stock trade but also enables you to better manage your risk-to-reward ratio.

Bonus Multibagger Stock Trading Idea: How to buy stocks online?

Buying shares online has never been easier. You can actually buy a lot of different assets today from various online platforms and brokers. Proper research on the services offered and the charges involved is the first step. It is easy to find out where to buy stocks online, but which online trading site is the best?

Why dont you check out the best online trading websites mentioned in this stock brokers guide review.

 “My team and I put together a comprehensive online stock brokers guide where we discuss regulations, things to consider before investing (or if your should at all), the difference between online stock brokers and full-service brokers, self-directed vs managed portfolios, the information needed to invest, and things to watch out for when investing with an online stockbroker.” – Giancarlos, ConsumersAdvocate.org

If you have understood the above Dividend Discount Model, Yield Curves and the ideas on Risk Management, then  you are prepared to buy stocks online. You can register with the brokers mentioned in the review.

Transaction costs by your online broker can make a significant impact on your long term portfolio growth. Competition among these top online stock trading sites is a great thing for Investors. Brokerage commissions decrease and services improve.

You can invest in a diverse range of asset classes through these stock trading sites. From Stocks, Bonds, ETFs and Mutual Funds, you also can invest in Derivatives like Options and Futures.

Forex Trading and Leverage: Too good to be true

Many of these trading sites also enable you to trade in Forex. But I would really not advice that to anyone looking for a quick buck. Forex trading requires a lot of discipline and sound money management.

When you trade Forex, you usually trade a currency pair with a leverage. Forex trading companies always entice you with attractive leverage offers like 100:1. By pledging 1$ to your broker, he lets you trade 100$. Hence, if those 100$ becomes 101$, you made a 100% profit with a 1$ investment, but if the 100$ becomes 99$, you lose your 1$ investment to the broker in a 100% loss.

Stock Expert Advice to find best multibagger stocks 2017

Hence, my personal advice is to trade stocks over FX. Actually, I would advice you to just Invest in good equity and not try to speculate the markets in Trading until you really understand things well. Build a strong stable dividend paying equity portfolio first. Then you can make riskier trading bets with your new income stream.

By the time you have built yourself a stable portfolio that you can be proud of you should be prepared to trade. But if you have mastered the art of money management and stop losses, then you may go with stock options. Of course I would recommend you to do a Masters in Finance or at least a CFA before you trade derivatives. A good understanding of Derivatives can help you devise optimal trading strategies.

If there is one thing I regret from my multi bagger stock picks, is that I did not invest enough. But I am at least glad that I got started and my Investments have grown considerably since I started.

Every 1% rise in my portfolio now is over my past gains and hence yields me a bigger return on costs. Start Stock Investing today, if you want to start Stock Trading tomorrow.