Personal Finance Solutions for India

Simple rules in stock selection for avoiding your risks
Shiv N. Majumdar

Defined Tag: Stock Market.

To realize your gains in the stock market, your stock selection is going to be the key step. Diversification, or spreading your eggs in different baskets, is well known. But which egg should qualify to be placed in your baskets does not get sufficient attention.

While we are in the stock market to extract a decent return, we must not act like compulsive gamblers. Even good gamblers have their risk reduction strategies.

Which risks are we most concerned with? The uncertainty of the stock market as a whole, like the risk of a loss due to a crash following a war or a sudden catastrophe, is not a concern to us once we have decided to enter the market. Our additional return from the stock market will flow only because we have decided to pay the price of this overall uncertainty.

Specifically, we can control the risks inherent in buying a particular stock. For example, is it a stock with good liquidity? Suppose we wish to invest Rs 25,000 in a particular stock and the daily transaction volumes are only in the region of a few lacs, then the liquidity in the stock is restricted. There are players who bet on stocks with limited liquidity because it can also move up faster. But this upside has a big downside, which is you may not be able to get out of the stock when you wish because there may not be ready buyers to sell to.

Next important aspect is: whether the price at which you are entering a stock is a fair price? Just because there has been a big increase in its price recently does not make it fairly or unfairly priced. Players use various ratios, inside information, tips, and educated guesses to resolve this issue. But if the company is shady, there may be unseen risks, which you will discover only later. By courting a shady company, you are unnecessarily meddling with something of suspect quality. It is better to be safe than sorry. Therefore, it is better to do some homework on this aspect.

In your eagerness to hold on to some thing with a great upside potential, you may forget to examine why the prevailing price of the stock is so low now or in the recent past. Researching on this aspect will be very valuable especially if the particular company's stock price is not in line with others in the same business or industry.

For lay investors, one simple rule to remember would be that high risks would accompany high returns. In the risk-return scale the various types of company shares in ascending order would be defensive stocks, established growth stocks, emerging blue chips (now referred to as mid-caps), re-rating candidates like turnaround companies, divestment of PSUs or companies benefiting from some expected fundamental changes in economy, regulations, technology etc.

One more simple and practical way to broadly determine the risk-reward equation would be a reference to the size of the company by market capitalisation. Market capitalisation means the price at which 100% shares of the company can be purchased at current market prices and would be equivalent to the amount you will obtain by multiplying the current price by the total number of shares issued by the company. Viewed by market capitalisation, larger companies would have lower risks and return potential but will involve lower unseen risks. In this way, you are using the judgement of the entire market to your advantage. Let us consider an example. Infosys has a large market cap. Polaris Software has a much smaller market cap. Profit potential and risks will be lower in Infosys compared to Polaris Software. Similarly, for any industry and also across industries normally.

Many people are unhappy that leading newspapers only carry prices of larger companies' shares. Actually such smaller lists serve as lists of shares with limited risks.

<b>Shiv N. Majumdar</b> is a Mumbai-based Chartered Accountant who specialises in <a href="http://soundpersonalfinance.com/">Personal Finance Consulting</a>.