How to Structure an Investment Plan and Make Your First Transaction
If you are new to the stock market and have recently opened a Demat account for buying and selling stocks, you might be wondering how to get started with trade execution. What is the right method to participate in the stock market? What to do after buying a stock? How to earn money and build your wealth from it?
Before you make your first transaction in the market, you must create a viable investment or trading plan. In order to structure a plan that is right, it's important to understand where you're at and what you want to accomplish with the investments. Then, you'll define how to reach those goals and select the best securities to reach them. Ultimately, everything boils down to how and when you transact securities. Let’s look at the right approach to investing and trading step-by-step.
Set Your Financial Goals and Determine Your Risk Profile
Prior to jumping into the market, the first step is to understand your risk profile. It is a combination of your risk tolerance and risk appetite. Risk tolerance refers to the amount of risk a market participant can handle. It can vary with age, income, responsibilities, etc. Meanwhile, risk appetite is the amount of risk that the participant is willing to take in order to achieve his or her financial goals. This is more of a psychological factor.
For example, an investor who is nearing his retirement is most likely ‘risk-averse’. Such an investor, who doesn’t want to or can’t take risks with investments, may rather want to maintain his portfolio’s value or settle for meager growth. On the other hand, an aggressive investor - say, someone in their 30s who has dispensable money from the sizable income he earns - is willing to take higher risks with the money and withstand market volatility in hopes of higher returns.
Risk profiling helps a market participant find the optimum level of risk that he can take to buffer from an unforeseen fall. Overall, it defines an investor’s participation style i.e. trading or investing. A trader buys and sells multiple times and plays on predicting and profiting from market sentiments. An investor is more of a "Buy and Forget" type. He or she buys a share that he thinks will do well in the long term (could be 6 months, 1 year, or even 10 years - no upper limit).
Choose a Stock Category that Matches Your Risk Profile
Based on your participation style, you determine the asset classes and instrument types suitable for your goals. Stock market investors must have sufficient knowledge to determine which stocks are the right choice for their investment strategy. Risk varies from one stock to another and if you have no clue about which stocks you should put money in, you could face losses.
One way to choose stocks that matches your participation style depends upon stock classification into large-cap, mid-cap, or small-cap based on their market capitalization. Market capitalization refers to the total number of outstanding shares of a company in the market multiplied by the current price of each share. It is a measure of the estimated valuation of a company.
- Large-cap companies are businesses that are well-established and have a significant market share. These companies dominate the industry and are very stable. If you want to invest in a company’s stocks by taking less risk, then large-cap stocks are a good option.
- Mid-cap companies are companies whose market cap is above Rs 5,000 crore but less than Rs 20,000 crore. Here, the possibility of risk is higher as mid-cap companies are less able to cope with market volatility than large-caps. On the other hand, mid-cap companies also have the ability to turn into large-cap companies in the long run. These companies offer a higher growth potential than large-cap stocks.
- Small-cap companies are those that have a market capitalization of less than Rs 5,000 crore. These companies are relatively smaller in size and have significant growth potential. What makes them risky is the low probability that they will be successful over time. This makes the stocks of such companies volatile in nature.
Narrow Your Focus to Desired Industries or Sectors
Using the top-down approach, Investors can attempt to earn better-than-market returns by pinpointing the hottest sectors leading the market higher, and identifying the best stocks within those sectors. For example, the technology sector might be up 10% versus a 3% rise in the overall market, as measured by a benchmark such as the S&P 500 index.
By analyzing several time frames, we can pick the best-performing sectors that are not just performing well right now but have been showing strength over a longer period. The time frames that investors choose will depend on their investment time horizon. Investors can choose a few of the top sectors to create diversification.
Research and Analyse Stocks
Once you have decided on the industry and the stock category, you need to find out what to buy or sell and at what price. Your aim should be to deeply probe the affairs of the companies on your list by analyzing the financial statements and all other available information about the company.
There are two primary methods used to research and analyze securities: fundamental analysis and technical analysis. Technical analysis uses past data of a stock to predict future price movements. Fundamental analysis instead looks at economic and financial factors that influence a business. Individual investors should use these methods to identify potentially undervalued stocks and set price targets.
Looking over analyst reports is the best way to start your own analysis. However, you don't have to blindly follow sell or buy recommendations that analysts make, but you can read their research reports to get a quick overview of the company, including its strengths and weaknesses, main competitors, industry outlook, and future prospects. It’s a best practice to do your own research before making a trade or an investment
Always keep in mind that trading or investing in the share market requires research and analysis. If you lack knowledge or need support, do consult a qualified financial expert for the same.
Create a Trading or Investing Plan
A trading plan outlines how a trader will find and execute trades, including under what conditions they will buy and sell securities, at what price they will enter, how large of a position they will take, how they will manage positions while in them, what securities can be traded, and other rules for when to trade and when not to.
- Favorable market conditions for buying or selling securities
While analyzing a stock, you can find opportunities to earn from the stock market in broadly two ways. If your analysis shows that the market is in an uptrend–called a bull market–and it's likely to continue for some time, you want to buy stocks that are showing the best potential to be big winners. However, just because the market is moving higher doesn't mean that all stocks will perform well, and some will greatly outperform others.
If we are in a bear market–or price declines–the investor could engage in short selling. Short selling is an advanced strategy that speculates on price declines in stock and should only be considered by experienced investors. Short sellers identify and sell the stocks likely to perform the worst and earn a profit as prices fall. - Best market price to enter a trade
Once you understand future earnings, the next step is to know about the worth of a company. You need to find out how much the current market price of the stock is justified in comparison to the company's value.
There is no "correct value," and different participants use different parameters. Value investors look at intrinsic worth whereas growth investors look at earning potential. A company selling at a higher P/E ratio must grow at a higher price to justify its current price for growth investors. This is how one decides the entry price for a trade. - High and low targets of a trade
The final step is to set a target price. Once you understand the different ways to predict future earnings, you can calculate a high and low target price by multiplying estimated earnings per share (EPS) with the estimated high and low P/E Ratio.
The high and low target price is the price band within which the future stock price is likely to move in response to the expected future earnings. Once you know the target price, you can very well use it to reach your destination.
Placing an Order to Enter a Trade
With your decision to trade or invest in your selected security, you need to log in to your trading account (provided by your stock broker) and place an order to either buy or sell. Once you place an order, the following details are validated –
- Details of your trading account through which you intend to buy or sell shares
- The price at which you intend to place the order
- The number of shares you intend to buy or sell
Before your broker transmits this order to the exchange, the broker has to ensure you have sufficient money to place an order for these shares. If yes, then this order hits the stock exchange. Once the order hits the market, the stock exchange (through their order matching algorithm) tries to find sellers or buyers who are willing to sell or buy shares of your desired security at your favorable price.
Remember before entering a trade, you must have a set target and stop loss in your mind for that trade. Always stick to your plan and trade within a pre-decided range. If the share that you bought goes below a certain price level, exit. There is no point in holding on to greater and greater loss, in the hope that the prices will rise later.
Hold or Exit Your Position
After you buy the shares, the shares will reside in your Demat account. You are now a part owner of the company to the extent of your shareholding. By owning the shares, you are entitled to corporate benefits like dividends, stock splits, bonuses, rights issues, voting rights, etc.
However, to realize the gains generated by stock price movements, one has to take an exit from their investment/ trade. The exit price and holding period depend upon the market conditions and your pre-set target and stop loss.
The holding period is the period you intend to hold the stock. You may be surprised that the holding period could be as short as a few minutes to as long as ‘forever.’ When the legendary investor Warren Buffet was asked what his favorite holding period was, he replied ‘forever.’
Check your positions in your Demat account to see if they're performing according to your goals. If not, re-evaluate your investments and determine where changes need to be made. Ultimately, everything in markets boils down to one thing. Generating a reasonable rate of return! All past stock market sins are forgiven if your trades generate a good return.