Planing to start investing stocks on your own? I am Glad you landed up here..
Innumerable times we heard the advise "Stick to the basics". Yet when it comes to investing, we idolize the person who uses the smartest jargon to mesmerize us. We somehow believe that investing is a complex activity in which the one who talks in the most perplexing way is a sheer genius. The reality though, is entirely different. Investing is a simple activity in which the one who has an average IQ often outsmarts the genius.
Your first stock purchase should be a company you know very well
Peter lynch (the world's most successful fund manager) conducted a test.,he asked primary school children to pick stocks. So the children picked companies such as Disney, Coca Cola, barbie etc. He then compared the return of these stocks to mutual fund schemes for 5 years. Interestingly, stocks picked by these kids out performed more than 50% of the mutual funds. Basically, we will succeed when we buy companies that we know. In the beginning of your investing life, this usually means companies that are into consumer business and sell 'touch and feel' kind of products. Colgate, Gillette, Bata, Nestle, Tata global beverages, etc are examples of such type of companies. "Buying what you know" works because It is easy for us to determine the performance of such companies and we can analyze their business activities on a day to day basis at the ground level. In the long run, the return on investment you will get will directly be related to the performance of the company, So buy a company whose performance you can actually observe.
Ironically, we adults do the exact opposite. Doctors (who should be buying pharma stocks) buy technology stocks because everything about it sounds like magic to them. Similarly, engineers buy pharma stocks instead of all the engineering and capital goods options available to them. This natural human tendency of venturing in the unknown in the hope finding a gem is a very costly practice in investing .
But hey, i won't able to buy 95% of the companies if i follow that rule !
This is the first question that arises when the rule of "buying what you know" is discussed. You need not worry about that, because it only solves the problem of plenty (more than 5K listed companies in India). The narrower your circle of competence, the simpler it is for you to pick out the investment worthy companies.
Let's take an example to understand the viability of this rule better.
Suppose you buy 2 companies, Colgate and an imaginary company called NextGen revolution. After 2 months, both the stocks are down 20%. Which company would you trust now ? My pick would be Colgate because i know that people will continue brushing their teeth and Colgate is not going anywhere. So knowing the company that you hold helps in taking rational decisions in the face of adversities.
P.S. - The next time you hear about a revolutionary company that will change the world in day Kindly ignore it !
*Disclaimer - Finology is an educational initiative and is not registered under any SEBI regulations. All the information that we provide is just for educational purposes and you should consult your financial adviser before taking any investment decision. Read the complete disclosure here