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03 June 2014

Schumacher is wrong, small is not beautiful (In Stock Investing)...

While investing in stock market, there is a rookie mistake that retail investors make. 

Number of shares is given more importance than the return on your investment.

Let us say that you have Rs.5000 to invest. You have a choice between two stocks. One, that of ABC Ltd is trading at Rs.50 per share. The other of XYZ Ltd is trading at Rs.2500 per share. 

Which company shares will you buy?

If you  are like what I was about 3 years ago, you will do a calculation as follows.

If I buy ABC Limited, I will get 100 shares and in case of XYZ company, I will get only 2 shares. 100>2 ergo, I will buy shares of ABC Company. 

Another logic that you will use, like I used to do, is that if the company declares 10% dividend, you will get Rs.100 in case of ABC Company and Rs.2 in case of XYZ Company.

There are many fallacies here that I have learned over the course of having made losses multiple times. 

1. There is a reason that ABC and XYZ are trading at the respective prices. ABC is a novice, it is just testing the waters. XYZ is tried and tested. It has a history of giving good returns on Investment to the share holders. Many people want to buy that stock and that is why it is trading at a higher price. You must at least analyse why the respective shares are trading at their prices. 

One reason may by that ABC is in an industry undergoing recession. For example, if ABC is a company in commodities, its share price will be low during Commodity Downturn.

Another important reason the share price of ABC is low may be due the large quantity of floating shares available in the market. Due to the sheer number of shares, the price per share will tend to be very low. The share price will find it very difficult to climb upwards since for every rise in share price there will be many people who may want to offload their shares. 

2. What about the dividend calculation, you may ask. As per my math, you may say, ABC will give me Rs.100 while XYZ will give me only Rs.2. To you my counter question is, have you checked the dividend history of XYZ before you did the math? Chances are that it will give dividends much in excess of 10%. Total dividend from XYZ may turnout to be much higher than Rs.100.

Anyway, you are not buying stocks only for dividend. Most of the return that you expect from a stock is through capital appreciation. 

Which brings me to my next point.

3. Look for the expected Return On Investment, not on the number of shares that you have.

As an investor, you are investing Rs.5000 and you are looking to maximize your ROI. Since most of the ROI in stock investing will come from Capital Appreciation, you have to look at how fast your investment is expected to increase. For example, if you are looking at a return of 50% on your investment, the price of a share of ABC purchased at Rs.50 has to increase to Rs.75, while the price of XYZ purchased at Rs.2500 has to increase to 3750. Since there is more demand for the shares of XYZ, the chances are that the price of XYZ will touch 3750 quicker than price of ABC touching 75. 

I learned these lessons about three years ago. While looking at my portfolio, I found that absolute value of my returns, for the same amount invested, was significantly and consistently high for the shares of companies like XYZ, (Large Caps, as they are called) than for the shares of companies like ABC (Small and Midcaps). To get a good absolute return in ABC Company, I have to invest significantly high amount of money in those companies and that was leading to increase in my Risk Profile. 

I also found that over a multi-year, large caps have given me positive returns irrespective of at what price I purchased the shares. I remember that I had purchased shares of a company at 1100 about 3 Diwalis ago, and price having gone down to 300 in the interim, it has climbed back to my purchase price.

And I received good dividends and one bonus in those three years !.

So friends, here is my advice. While investing in stocks, always focus on Return On Investment and never focus on the number of shares that you are buying.

Despite what Schumacher says, small is not beautiful when it comes to investing in stock market.

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