Every investor in stock market faces two choices when it comes to investing. Should they buy it for long term or decide to square off based on the price movement in short term? Usually the long term buyers are called investors who expect the price of stocks to appreciate in the long run while the short term buyers are called speculators who want to take advantage of short term fluctuation of the prices.
We will focus on long term investing in this article. Let’s look at some of the techniques that long term buyers use to achieve the required return from the market.
Buy and Hold strategy
This strategy involves buying stocks and holding them for long periods of time. The buy and hold strategy is one of the most widely used strategy by value investors. Warren Buffet, Peter Lynch, and Philip Fisher are few of the investors who have used this strategy to achieve extraordinary returns in the market. Back home, we have Rakesh Jhunjhunwala who has earned his name (and money) in long term investing.
The investment can increase in three ways:
Dividend: Stockholders are entitled to receive the dividend that companies pay from time to time. The investors can reinvest the dividends or invest in other assets immediately to take advantage of compound returns.
Price appreciation: Price appreciation of stocks is another way to achieve higher returns. We know, by empirical evidence, that stocks give the best returns in long run.
Stock split: Some companies split the stocks when the price of a single share becomes too high for a common investor. Typically, when companies split the stock, its demand goes up because investors who could not afford to buy the stock before can now afford. This new demand increases the price of the stock.
Rupee Cost Averaging
Rupee cost averaging is another long term strategy used by investors who want to avoid the market fluctuation in short term. Rupee cost averaging is investing a certain amount of money in the same stock at equal interval. This strategy has given phenomenal gain to common investors who are disciplined enough to ignore short term price changes.
For example, an investor invests 10,000 in Tata motors in Jan, 2009 at Rs 100 a share. Thus he can buy 100 shares of Tata motors. The investor again invests Rs 10,000 in Feb, 2009. If the price of Tat motor’s share is Rs 150 a share, he or she will be able to buy 67 stocks. Similarly, the investment occurs every month. The amount Rs 10,000 is constant. The number of stocks bought each month will change depending on the price at the time of buying.
The advantage of this strategy is that it eliminates the effect of price fluctuation and averages the price of the stock. This strategy also prevents investors from falling into common trap of buying high and selling low. It has been observed, historically, the rupee cost averaging is a potent weapon for investors who want to achieve good returns in long term.
A close cousin of rupee cost averaging is systematic investment plan (SIP) which is generally preferred in case of mutual funds. The concept is similar. In SIP, you have to define three parameters. How much to invest, the frequency of investment, and the investment horizon. SIP also works on the principle of rupee cost averaging.
Hence SIP and rupee cost averaging are the best ways for investors who lack time to keep an eye on the price movement. The biggest advantage of both the system is that it builds the discipline in investing as well as wealth.
The third long term investing strategy is investing in mutual funds that follow a widely used index. Investors can choose from a plethora of indexes available in the market. Some of the indexes are Sensex, Nifty, Bankex, etc. These indexes track performance of the companies that form these indexes. Essentially it is a passive approach to investing where investors expect to achieve competitive returns in long term by investing in a benchmark index. Index investing helps in two ways:
The fee usually is much lower compared to other mutual funds. Typically average expense ratio (the % of money paid for the management of fund) is half of the sum paid as expense ratio to other mutual funds. Index mutual funds track the returns of major indexes in the market. The market has been shown to give good returns in the long run. Hence the index fund will also provide similar returns.
Long term investing is the only way to invest your hard earned money if you do not want to or do not have enough time to follow the stock market. Build the necessary discipline to follow the long term techniques and watch you wealth grow.