Everyone would like to know and buy at a price that will remain the lowest price among all the future quotations. But knowing such a price is a mirage. Hence, a better question worth contemplating is: How not to pay too much? Such a mental state makes it imperative to focus on the process, which is very specific to every individual and needs continuous refinement. Here is my thinking that precedes the process I follow:

• Firstly, no silver bullet exists.
• Secondly, the price trend is a good indicator of prevailing psychological factors (supply-demand, narratives, recent performance compared to prior expectations, and adjusted earnings expectations) in the near term. However, the price CAGR results from long-term earnings performance.
• Thirdly, analyzing fundamentals is a must exercise to develop conviction. Look for mispriced opportunity, basis fundamental triggers [earnings growth, optionalities, nature of the business (terminal value, B2B Vs. B2C, type of product , opportunity size, Cyclical Vs. structural demand, reliability of the cash flows), capital allocation, etc.] that are yet to reflect in the price.
• Fourthly, value is a fact and growth is an opinion. As it is impossible to forecast the market’s mood, work patiently to find mispriced bets that are unrelated.
• Ultimately, future outcomes are uncertain (amount and the timing of the cash flows, financial shenanigans, unexpected economic shocks such as COVID, Red Sea fiasco, etc.). Valuation is not only subjective (Investment horizon, Expected Returns) but also relative [current market state (bullish/bearish), sectoral tailwinds, liquidity in the system, intangibles (competitive advantages, financial strength, management) of the business that are very important even though they cannot be measured and processed by mathematical models].

Hence, valuing with precision is impossible as too many variables influence valuation, making it imprecise and subjective. In turn, self-doubts magnify as and when the price starts to correct. The only place to direct our efforts is in the process of thinking about the prices. My process begins with a price chart to sense the current trend. This step makes it easier to process many names quickly compared to the approach of fundamental analysis, & highlights the names that are in demand in the current market environment. Price trend will fall in one of the below three categories:

• Up: Analyze fundamentals. The story seems interesting. However, the price has already run up too much. Track and wait for price pullback (continuation patterns). Take a position as and when the opportunity arises.
• Down: Analyze fundamentals. The story seems interesting. However, market participants are not interested in this name. Track and wait for the completion and confirmation of the price correction (base formation patterns). On pattern confirmation, take position only if fundamental factors are still promising.
• Rangebound: Analyze fundamentals. The story seems interesting. The ongoing price trend implies that market participants are yet to make up their minds. Track and wait for the completion and confirmation of the price correction (base formation patterns). On pattern confirmation, take position only if fundamental factors are still promising.

Overall, analyzing fundamentals is a must. Always start with technical factors to decide the name to be analyzed deeper. Analyzing fundamentals provides the conviction to size positions and calmness during moments of volatility. Basing the decision on such a hybrid approach reduces the uncertainty range and helps to ride the uptrend with confidence. However, even this approach will not be able to find only winning bets.

Ultimately, one attains the best path to follow by continuously refining their process.

With or without reason, stock prices fluctuate. This behavior is known as volatility, and it makes equity investment risky in the minds of the masses, specifically when the price falls after one buys the stock. Even though disliked by most market participants, volatility is and will remain an integral feature of equity investment. Since eliminating volatility is not feasible, one needs a robust thinking framework to understand volatility’s true nature and devise a good action plan. The perspective provided by such a framework will make one start liking and benefiting from times when volatility unfolds.

When faced with volatility, the mind is filled with emotions such as hope and fear while contemplating financial matters. Hence, the thinking framework must be capable of providing insights into hope and fear to demystify volatility. A 2×2 matrix discussed below provides the easy-to-comprehend framework. In each category on this matrix, the mind assesses and selects competing choices using loss aversion tendency, which means that losses are weighted at least 2x that of gains.

Let’s imagine a 2×2 matrix. Matrix’s Y-axis represents probability ranging from possibility (+Y) to certainty (-Y), and the X-axis represents net result ranging from gain (+X) to loss (-X), resulting in four categories that imply an individual’s mental state under different circumstances: the possibility of a gain (PoG), the possibility of a loss (PoL), the certainty of a loss (CoL), and the certainty of a gain (CoG). Among these four categories, two (PoG and CoL) evoke hope with risk-seeking behavior, and others (PoL and CoG) evoke fear with risk-averse behavior.

Let’s delve deeper into each of them.

1. PoG (the possibility of a gain) is apparent when someone contemplates buying a lottery ticket. The probability of winning is negligible, yet people exhibit risk-seeking behavior and buy the ticket because the hope of a big payoff provides immense pleasure to the mind. Luckily, people bet an insignificant amount compared to their net worth. In the investing world, it is akin to buying the stocks of questionable businesses. It’s best to avoid investments falling in this zone as these are long shots due to a lower probability of winning, which results in a lower conviction that limits the bet size. A smaller bet size can’t enhance overall portfolio returns even if it turns favorable.
2. CoL (the certainty of a loss) is noticeable when someone contemplates selling a stock position that is in loss. The choice is between booking a confirmed loss now or keeping hope alive to break even with time. Selling converts a notional loss to reality. Selling at a loss is repulsive to the mind as it acknowledges one’s mistake. Hoping to break even sooner, an investor exhibits risk-seeking behavior and buys more at the prevailing price. The sunk cost fallacy prevails in this category. A bad situation could quickly turn worse. Instead of deciding to buy due to the fall in the price compared to the original buy price, an investor should be mindful and revisit the original thesis to decide further course of action. Either hope to break even by buying more with a solid rationale or accept the mistake and close the position without regret or disappointment.
3. PoL (the possibility of a loss) is observable when someone contemplates buying insurance for a car. Although the probability of an accident and a huge loss is negligible, people exhibit risk-averse behavior. They choose mental peace and purchase insurance to eliminate the fear of a huge loss. This category is observable in investing when someone needs to hedge a portfolio using options to mitigate equity drawdowns, leading to continuous expenditure and management. I think it’s best managed by avoiding leverage and keeping a long-term investment horizon.
4. CoG (the certainty of a gain) is noticeable when someone contemplates selling a profitable position. Fear of giving up certain gains motivates the mind to sell off the profitable position instead of directing the focus on the future potential of the stock. By ensuring sufficient diversification and buying proven and sustainable businesses, an investor can transform his behavior from risk-averse to risk-seeking. Doing so will ensure that one does not sell the winning positions under fear and can create serious wealth with equities for oneself and loved ones.

The 2×2 matrix provides insights into the constant interaction among volatility, hope, fear, and investor behavior. This mental model quells my fear of equity investment and makes me understand volatility as a friend who intends to provide immense benefit. I hope it does add another perspective to your thinking as well.

Risk is ubiquitous as it’s integral to everyday earthly matters. Everyone may not explicitly consider and think about risk but must handle risk for everyday chores such as buying car insurance, selling winners, and averaging losers. Risk takes center stage in decisions related to investment matters, particularly equity investment. Investors invest now expecting to earn more in the future, which is highly uncertain. Hence, it becomes imperative for a thinking investor’s mind to understand the overall concept of risk. The simplest definition of risk, in my opinion, would be that the expected outcomes are only a subset of all the outcomes that are likely to happen.

Risk is hidden, subjective, and non-quantifiable. It can’t be completely measured or eliminated. However, it can be controlled, transferred, or distributed. In equity investment, an investor shall focus on two main risks: loss of own capital and earning a return lower than alternative opportunities. All the investment risks can be categorized into two major heads: systematic (external) and non-systematic (internal).

Systematic risks are uncontrollable and impossible to predict in advance, either their timing to start and end or their degree of impact. However, experts attribute them to recurring macro factors such as changes in interest rates, inflation, natural calamities (like COVID), and national and international situations like war, political changes, etc after they become a public secret. Unfolding systematic risks changes the attitude of the market participants to excessive pessimism and affects most stocks, correcting them by varying degrees. These risks increase uncertainty in the minds of the market participants and cloud their judgment, making them think emotionally rather than objectively. During these moments, investors’ preference for risk quickly jumps from one extreme to another extreme, risk-seeking in regular times but risk-averse in difficult times.

Even though systematic risks are uncontrollable, a good action plan can help to handle them gracefully. Firstly, invest long-term savings in the equities for the long run. Secondly, be aware that intermittent drawdowns in equity instruments are a norm. Instead of selling in such a distressed moment, keep the investment horizon in mind and do not panic. Thirdly, avoid or limit leverage to take investment positions else forced selling will be inevitable. Finally, use this as an opportunity to buy more. Overall, always maintain liquidity and be prepared with ideas to create immense wealth.

Unlike systematic risks, non-systematic risks are due to factors that impact individual companies or industries. The list of factors contains method, instrument, horizon, quantity, and nature of the business and industry. All these factors can be controllable by following proven risk-mitigating approaches such as following a robust process that is updated with the latest learnings, knowing and understanding the instrument of interest, being mindful of the investment horizon, diversifying positions till ready to bear risks of concentrated investing, considering financially sound businesses for investment, and staying vigilant about or weeding out industries that are prone to lose money historically.

In times of risk unfolding, the continuum of the probability of an event ranging from certainty to possibility hardly comes to thoughts, making emotions prevail. The practice of selling winners and averaging losers is followed by novice investors even though it results in poor outcomes. Where does all this leave us? One who invests in equities has fear. One who has fear must think of risk. One who thinks of risk aligns his actions to survive lethal shocks. Overall, one should develop suitable thinking to handle risk since wishing it away is not an option.

The short mental model to build an equity investor’s thinking about risk could be: Be aware, analyze, diversify, and do not pay too much in exhilarating times.