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As investors, we have all had our fair share of bad experiences with the stock markets. From alleged management frauds to the global financial crisis, the recent covid pandemic and sometimes simply it’s our stock picks that don’t work out the way we had thought they would! We will let you in on a little secret. Investment professionals too have these experiences, but they have gotten really good at concealing these facts.

Fun fact, top investor Warren Buffett has a success rate of only 58% when it comes to picking the right stocks. In fact, in fund management, this ‘hit rate’ is absolutely enviable! Buffett once mentioned that even if an investor merely hits 50% of right stocks in his entire portfolio, implying the other half would be rotten picks, he would still be able to earn supernormal returns!

Imagine you have selected 10 stocks for your portfolio through your own rigorous due diligence and research and held on to it patiently for a long period, say the next 40 years. Now, equate the first case to a scenario wherein five of the 10 stocks in your portfolio performed exceptionally well, generating 15-30% CAGR. While the other half of the portfolio eroded shareholder wealth completely. An interesting observation is that the compounding returns of the right stocks more than makes up for the losses of the other ones and if held for a long time progressively and significantly grows the investor’s capital over time. Yes, that’s right, the winning stocks proved to be more than capable of overpowering even the negative 100% returns of the losing ones, earning an overall positive return on the entire portfolio in the long run. In fact, the returns keep magnifying as he/she keeps extending his/her investment time frame, thanks to the power of compounding!

 

Accuracy in stock selection may not be in our control. But due diligence and thorough research definitely is.
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Accuracy in stock selection may not be in our control. But due diligence and thorough research definitely is.

Now, consider a second scenario wherein even after thorough research and conviction, the investor’s picks went completely wrong in all but one stock. You may think, there goes all my money down the drain! But the results would stun you! Turns out, if your conviction on even one of the stocks turns right and you stick to it, you are still bound to earn lofty returns in the long run! Meaning, even if a single stock yields a 30% CAGR with the others losing 100% completely, your entire portfolio is still bound to earn a healthy 22.73% return if held on for the next 40 years. The compounded returns of the one right stock has the power to not just exceed the other loss-making bets but also turn around your portfolio’s entire investment performance in the long term.

What’s all the more fascinating is the fact that in just a few years, the entire portfolio starts exactly mirroring the performance of the winning stock! Why does this happen? The answer is simple, limited downside risk and unlimited upside potential! Sure, the losing nine stocks may vanish your investment capital completely from those respective stocks. Worst-case scenario, they can reduce down to zero, but that’s about it; your downside risk is capped at zero. The investment definitely cannot fall beyond zero, right? However, for the winnings of our right pick, the sky is the limit! Year after year, money from your investment in the winning stock would keep growing, intensifying your returns from the stock, all thanks to the magic of compounding!

The takeaway is clear: don’t be afraid if you have fallen prey to choosing some wrong stocks. Choosing a winning stock is a difficult task, given the uncertainty about how companies compete, expand and adapt, potential technological disruptions, the impact of regulations, an out-of-the-blue pandemic—the list is endless. So, don’t worry about choosing a losing stock. We may never have the upper hand when it comes to foreseeing the future! Accuracy in stock selection may not be in our control. But due diligence and thorough research definitely is.

So, it’s best that we devote our time and attention to studying the stock, gaining a complete understanding of the business, its risks and opportunities, and the financial position. The rest is a game of patience! Our patience will bear fruit only in the long run.

Salonee Desai is senior equity research analyst, Moat Financial Services Pvt. Ltd.

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