The stock markets or equity markets are large market places or trading platforms in the modern sense of the word; where investors buy and sell equity shares or part ownership of various corporations representing various industries and services. To engage in this exercise of buying and selling equity shares the investor would be required to follow certain rules, to enable a successful and profitable conclusion to their transactions or trades.
We would get to these rules presently. However, investors are well advised to tread with caution and attain a certain level of comfort with the system they propose to implement. After all a system which works for one person may not necessarily work for another person. A dry run on paper would be in order for a period of time before the investor implements his or her system in real time in the stock markets. Further, we would restrict the application of these rules to the equity markets or the cash market. The other two sub-markets being Options and Futures which are different investment instruments with their own risk-reward profiles and require a different set of rules.
The stock market investment rules are listed below:
1. Make investments in the larger companies with price-earning ratios (P/E) of 10 or below.
2. Keep investments limited to the top 2 - 3 companies in each industry or service group.
3. Invest in companies operating in high growth (or sun rise) industries.
4. The price-earning ratio and earnings per share are important tools to estimate the fair value of shares.
5. High price-earning ratio implies that:
- super growth is expected in the company's earnings in the near future;
- investor confidence is high; and
- watch out for low earnings per share ( an earnings per share of 15% of par value of a share is reasonable).
6. Low price-earning ratio implies that:
- investor confidence is low or poor; and
- a high growth stock or company not yet recognized.
7. High returns can be earned from high priced stocks with reasonable price-earning ratios. The best investment opportunities usually lie in the most unexpected places.
8. Apply the theory of contrary opinion:
- The crowd is usually wrong, go against the crowd.
- When everyone expects the market to decline, prices will rise; and when everyone expect the market to rise, prices will fall. Markets tend to do exactly the opposite of what everyone expects.
- In the early stages of majority opinion, it pays to follow or precede the crowd.
- Contrary stock market action pays off only when timed to coincide with the last stages in the consolidation of a widespread majority viewpoint.
- Sell a stock below the anticipated peak price. Always leave a little margin for the person who buys the share from you.
- Buy and sell stocks at intermediate levels. To put it in perspective, "Sell, regret and grow rich".
- The bulls make money, the bears make money, the pigs go broke.
- Never buy/sell in line with the prevailing market opinion.
- Habitual non-conformity is no more profitable than habitual submission to fashion.
- Buy when others are selling, and sell when others are buying. That is buy in depressed markets and sell in boom markets.
- Always ensure that your stand is supported by reason and logic.
- When majority opinion begins to dominate the market, watch for crowding in contrary opinion.
9. Preferential allotment should be treated as subsidiary opportunities for making money.
10. Rights issues enable fresh investment without dilution of ownership. It enables investments at prices below the prevalent market price of a stock. And also enables step up of dividend yield substantially.
11. Bonus shares expand the total shares outstanding, trading volume and liquidity of the share. It also raises the dividend amount and gives tax benefits. Further, it also acts as a signal confirming good future prospects of the company.
12. Timing your buys:
- Initially base investment decisions on selection rather than timing, unless you have an intuitive flair for predicting short term price fluctuations.
- For superior results learn to combine good selection with good timing.
- Time the buy at share prices close to the lowest price of the year. Last years average price would be close to current year's lowest price.
- Never buy shares at prices greater than or equal to peak price of previous year.
- Under normal conditions buy shares at prices between last year's lowest price and average price.
- In a rising market, buy shares at prices greater than or equal to previous year's average price. However, do not buy shares at prices greater than 10% of previous year's average price.
- Do not buy shares when they are in the limelight, as they maybe over priced. Alternative 1, buy the shares at early stage of publicity. Alternative 2, buy the shares when the publicity dies down and the prices fall.
- Do not buy shares immediately after a steep rise in prices, as this is usually followed by a steep fall.
- A sharp fall in share prices is an opportunity to buy. However, you should be confident that the fall is temporary; and that the future outlook of the company is good enough for a future rise in prices.
- If you have a promising growth stock in mind, and are looking for an opportune moment and price to buy it, the best time would be at the middle of its accounting year.
- Stock prices record sharp rise just before an expansion project of the company goes into commercial production. If you are a buyer, buy the stock a month before this happens. If you are a seller, sell the stock 2 months after the start of commercial production on an expanded scale to take full advantage of the stock or share price rise.
- Companies often issue press releases about expansion, diversification, new products, rising order book positions, proposed bonus/rights/conversion and so on. This has a bull effect on the stock prices. If you wish to buy the stock of such a company, do so on the same day the news is released. This same rule applies to companies with improved half yearly results.
- Buying shares immediately on receiving favorable news about a company is a good timing decision. It would be even better to buy the stock in anticipation of favorable news or market development.
- Keep a watch on the performance of similar companies in the same industry. Use this information to improve the timing of the buy decision.
- Improve your investment performance by staying and being ahead of the crowd.
13. Timing your sells:
- The best time to sell usually coincides with the stock market boom.
- Reasons why investors are unable to sell at the right time are that investors tend to marry their stocks. They are unable to accept mistakes and correct them. They desire to at least break even on the same stock. And on occasion are reluctant to pay capital gains tax.
- Reasons why investors sell shares are that they may have made a mistake in their initial selection. Periodic review and reconstruction of their investment portfolio. Enables investors to take advantage of market swings and new buy opportunities. Necessary for regular adjustment of capital gain/loss for tax purpose. And also to provide for regular spending money to meet seen and unforeseen expenses.
14. When to sell:
- When the price-earning ratio of a stock held in the portfolio shoot up to unrealistic levels.
- When the investor has made 100% to 200% profit on his or her investment.
- The investor has overshot his original objective.
- The investor incurs a loss of 8% to 10% due to a fall in the stock price. However, do not sell in case the loss is due to temporary and widespread decline in the stock market.
- Keep capital losses short term. Do not let tax considerations hamper a good sell decision.
- It is always better to sell too soon than too late.
- Sell after a steep rise in stock price.
- Do not sell stock immediately after a steep fall in price. Sell during a rally.
- Sell when in doubt.