Can you share with me some very smart rules of investing for beginners in the market? I am just about starting out in the stock markets at this point of time.

Stock can be complex and daunting if you are a first timer. Remember, the markets can be quite intimidating if you do not understand the nuances of the market valuations and the intricacies of how the price fluctuations happen. It is not about information or about data; that is available. It is about time. You have a short opportunity span and within that opportunity span you need to apply all your analytical skills to quickly evaluate the impact of some of the changes and plot it to the impact on the stock price. That is the challenge.

If you are a beginner in the stock markers, you are surely going to have a tough time navigating through the maze of information, analyses, research reports and rumours. It is much harder than you can imagine. There is no shortage of information and analysis to assist, but the big challenge comes in separating the wheat from the chaff. How do you separate the stock analysis from the sales pitch? How do you take a dispassionate view on the stock that you want to invest in? How to ensure that you do not end up buying on greed and selling on fear? Above all, how do you time your entry and exit into stocks?

If you are a beginner, you are going to have a tough time navigating through the maze of information and stock market jargons that is dished out. Here are some smart rules for beginners…

Set your target return and your target risk

This is the cardinal rule for stock market beginners. When you buy a stock, the upside is your return and the downside is your risk. If you have bought a stock and the stock is down by 20% what should you do? Since there are no easy answers, the discipline of a stop loss will come in handy. Similarly, on the upside, profit is what you book and all else is book-profits. So you must get into the habit of taking profits at regular intervals. No point in watching your notional profit in your online portfolio daily and then all of that wiped out by a major global risk factor, which you never factored. The moral of the story is that you need to start investing by setting limits on your risk and returns.

Understand the risk-return trade-off

This appears to be quite an esoteric topic but in reality it is quite simple. Let us assume that you have bought a stock and have an Rs.10 profit target! Should your stop-loss be Rs.10 below your purchase price or Rs.15 or Rs.5? The thump rule is that you trade or invest in markets with a positive risk-reward ratio. Your profit target should be at least 2.5 to 3 times your downside risk. Otherwise, your returns will never compensate you for the risk that you are taking on. Secondly, if you succeed as an investor over the longer term, you need to constantly keep raising your profit targets. This has to be progressively done as you get more comfortable in the markets.

Even Buffett spreads his risk and so should you

It is quite common for all of us to hear about case studies of famous investors who made their money in 1 or 2 stocks. They will always preach the merits of concentrating your risk in a few stocks. But that is betting too much on the luck factor and that is a bad premise to start off on your investment journey. The bottom-line is that you need to spread your risk across stocks, across themes and across asset classes. Remember, equity is one of your asset classes and not the only asset class you invest in. Look at themes that are not correlated to give your portfolio the benefit of diversification.

From the first day, only buy what you can understand

It does not matter whether you are trading or investing. You need to understand the stock you are buying and why you are buying them. Your justification could be fundamental or news driven or technical, but what is important is that you must be fully aware of the reason you are buying the stock. When you are unfamiliar with the nuances of the stock market it is very easy to get carried away by advice, tips and rumours. You must resist that temptation. When you buy a stock you are either buying the business, or you are buying a trend. It is OK either ways as long you are perfectly aware of what you are buying and why!

Know when to stay away from the market

At the peak of the technology boom in 2000, a rookie investor just could not bring himself to buy IT stocks although they were still appreciating. He chose to do nothing. It turned out to be a great decision as exactly 1 year later he got most of these stocks at 10% of their previous year prices. Remember, there is merit in staying out of the market. If you are not convinced by the story or if the market is too volatile or if the valuations are just disconcerting; there is merit in staying out of the market. It is ironic but true that when you look back; you will have made most of your money because you opted to stay out of a market you did not understand.

Keep a hawk’s eye on your capital

This is a rule that you must never let go off your radar. Remember, whether you book trading losses or investment losses, you are reducing your base capital. You must define your capital risk tolerance and stay within that limit. In fact, it needs to be remembered that as a trader or investor who is just starting out, the primary focus should be on protecting your capital. If that is taken care of, the rest will follow…

As we have said time and again, direct investing in stocks is not a cake-walk. You can learn along the way by focusing on your risk appetite and protecting your capital as well as understanding what you are buying. If all this is too much for you to handle, you can also opt for the safety and worry-free option of equity mutual funds!