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Basic Guidelines for Stock Investment

DEFINE YOUR INVESTMENT OBJECTIVES

A basic guideline is to understand what you really want from your stock investment:

  • Do you want to invest for the short term (1-3 years), medium term (3-5 years) or for the long term (5 years or more)?
  • Do you want to invest for dividends or for capital gain or for both?
  • How much risk can you take in terms of market downturns?

These are the basic questions you must address before investing.

Optimally, you may want to invest in stocks for the long term, in order to earn dividends (periodically,

through dividend yielding stocks) and for capital growth (gain in share price) over a number of years.

STOCK INVESTMENT BASIC CONCEPTS:

  • CAPITAL GAIN: Capital gain is attained by selling of shares at a higher price than purchased. Multiple such trades can result in multiple capital gain accruing to the investor.
  • DIVIDEND: Dividend is the return paid to shareholders out of the profits of the company. Dividend can be cash dividend or bonus dividend/shares. Dividends may be paid out by a company more than once a year.
  • DIVIDEND YIELD: Dividend yield is a financial ratio that indicates how much cash dividend a company pays in terms of its share price. Dividend yield is calculated by dividing the cash value of the dividend by the share price. It is defined in percentage.
  • EARNING PER SHARE (EPS): Profit after Tax divided by No. of Shares Outstanding. It’s a measure of the strength of the company in terms of its earning capability for each share issued.
  • PRICE TO EARNING RATIO (P/E): Share Price divided by Earning Per Share. It’s a measure of valuation and indicates whether the price of a share is realistic and is in-line with its earning. If the share is over-priced, then the ratio will be high and if the share-price is low, the ratio will be low.
  • BOOK VALUE OR BREAK-UP VALUE: Total Equity divided by No. of shares outstanding. This ratio indicates the asset coverage that each equity share represents in the company.

YOU SHOULD DIVERSIFY YOUR INVESTMENT

As mentioned earlier, it is important to have a diversified portfolio of investments. You can have a diversified portfolio of stocks in order to cushion the effects of market downturns & volatility and to keep your total investment relatively secure. You can diversify your portfolio by:

  • Investing in different products listed on the Stock Exchange such as stocks of listed companies, T-bills and mutual funds.
  • Investing in stocks on the basis of their financial performance and/or that of their industrial sectors.
  • Investing in stocks based on shares that give dividends or shares that provide for sufficient capital gain or both.
  • Investing in stocks with different risk/ return levels. Some providing greater returns while others providing less returns. At the same time, the risk level of former will be greater than that of the latter.

EVALUATE THE RISK TOLERANCE AND CAPACITY LEVEL

You must evaluate how much risk you can take/ what is your risk tolerance level if the market takes a downturn.

  • If you are risk-averse, your investment portfolio of stocks should be passive. In this way, you will be assured of receiving a return at market risk level.
  • If you are less risk averse, your investment portfolio can be a combination of stocks which provide for returns at market risk level and above market risk level.
  • If you are investing as an aggressive investor, you can invest in stocks which provide for higher returns reflective of higher than market risk.

Having a balanced portfolio with different market risk levels of shares and their returns is usually a good combination to build a portfolio of stocks. You must also understand your risk-taking capacity. How much are you able to invest in the stock market in the face of the downturns and volatility it is undergoing?

STOCK SELECTION – LOOK AT THE PARTICULARS OF LISTED COMPANIES’ STOCKS

In order to select the companies, you want to invest into, you may want to look at:

  • The fundamentals and financials of the companies. ● The volume of activity in the stock market.
  • The prevailing share price. ● The Price to Earnings ratios (P/E).
  • The Earning per Share (EPS). ● The industry/sector performance of the companies.
  • The indices in which the companies are listed (are they blue-chip KSE 100 Index companies?).
  • The annual payouts (bonus/dividends/any other) given by the companies.

The above are some of the guidelines you may want to go by in order to select the companies you want to invest into.

WHEN TO ENTER OR EXIT THE STOCK MARKET

It is a safe proposition to enter the stock market when the Price to Earnings ratios are low and the stock market is in an oversold position. Similarly, it may be profitable to exit the market when the opposite conditions are true. However, as a general rule, it is not when you enter or exit the stock market, but how long you can stay in it.