What Is the Most Important Thing when Investing in Stocks? How To Generate Steady Positive Income Over the Long Run.
In this article, we want to discuss the most important thing when investing in stocks. Many people think profits are the most important thing, but we would rank it as number three by importance level. Because in the end, it does not matter how much you gained from your investment if the recent stock market sharp decline reduced your capital significantly. The most important thing when investing is not to make your investment a lottery or a casino game. You need to consider your capital protection (FI, derivative instruments) or risk smoothing (portfolio management) to ensure you generate positive returns over the long run. It is the most important thing when investing in stocks or any other assets. Let’s talk about it in more detail.
We talked a lot about portfolio diversification. But let’s discuss why it is the most important thing when investing. Let’s say you have one stock in your portfolio. If something bad happens with the company or investor sentiment, you may incur significant losses or even lose everything if the share price goes to 0. You don’t want that. That is why you are trying to invest in different stocks to ensure some will rise. Is it a good diversification? No, it is awful diversification because you don’t consider your stock’s individual risk metrics and trading history.
If something bad happens, all the stocks in your portfolio may go in one downside direction. Maybe they will not, but you don’t know that because you did not examine individual stocks’ behavior in your portfolio. You may have stocks that will perform great when the market is booming and get great returns, but your portfolio is not considered valuable if you can encounter rapid sharp losses that will cover your gains. That is why portfolio diversification (an allocation that considers individual stock performances to lower the overall portfolio’s volatility) is the most important thing when investing in stocks.
Portfolio managers examine stocks by analyzing them, then create a variance-covariance matrix to see the stocks’ dependence (how your stocks in the portfolio correlate with each other and the scale of this correlation). Then portfolio managers calculate the portfolio’s standard deviation and the return. Afterward, portfolio managers assign weights to individual stocks to reduce the portfolio’s volatility to the minimum level. If you use Excel, you can use the Solver tool to assign the stock weights.
Another option for you is to use a web-based application, Diversset, to find great stocks tailored to your risk appetite and build an efficient portfolio. This app uses the Markowitz model to construct a well-diversified portfolio. Diversset automatically distributes stock weights so that you have the minimum portfolio volatility. With Diversset, you can now select filtered stocks and decide what stocks would be in your portfolio, and Diversset will build your efficient portfolio from your selection.
In the end, you will get your selected stocks with the weight of each stock that should be in your portfolio to lower the portfolio’s volatility to a minimum level. You will make your portfolio more resistant to the stock market’s sharp declines, and if you select true-value stocks, you will generate steady returns over the long run. You will not be protected from losses, but your losses will be lowered as much as possible, considering your selected stocks. Simply put, your stocks will rise when the companies deliver strong results, but the portfolio will not decline rapidly and sharply if the stock market experiences highly turbulent moments.
If you want to learn how to build an efficient portfolio manually and also want to know what portfolio is good for you if you are a risk-seeking or risk-averse investor or if you are interested in building your portfolio not only of stocks, you can take our Udemy, 11-hour course, called “Financial instruments and analysis. A practical guide”, where we teach valuations, risk management, and portfolio construction.
Now you know portfolio diversification is the most important thing when investing in stocks. What is the second most important thing? It is how well you search stocks based on your risk-return profile. If you find the wrong stocks that don’t match your investor profile, you may end up with a wrong trading strategy that will destroy your positive returns. Yes, your volatility would be limited, but you will have problems reaching your required return since you won’t know when to sell your stocks and how to act if the stock is getting more volatile, for example.
That is why it is essential to build your portfolio from the stocks that will match your profile because if you do so, you will understand your maximum holding period, your desired Beta, and the market. It will give you a clearer picture of your stocks and help you shape your trading strategy. Diversset will help you find stocks tailored to your investor profile.
And the final point in this story is your return. It is the number 3 thing by importance level. After you have found great stocks, built your portfolio, and understood your trading strategy, it is time to monitor your portfolio’s return and make necessary portfolio adjustments if the stocks in your portfolio get more volatile, for example, or if the companies showed financial reports, not in line with the analysts estimates.
Thank you for reading this article. We hope it was helpful.