When it comes to investing, some investors make the process harder than it should be.
There is a needless attempt to complicate a process that can be fairly simple.
But first, let us define what investing is.
Investing is a process where we deploy our capital to earn either income or profit.
In other words, by allocating your capital to promising businesses, you expect to earn either passive income (in the form of dividends) or capital gains through share price appreciation, or both.
Investors are seeking to make their money work harder for them, and investing is also a way for them to enjoy a secure and happy retirement.
However, the process need not be complex.
If you’re looking for a method of enjoying great returns on your investment portfolio, here are three simple steps you should take.
Selecting great companies
The first step is to identify great businesses to invest in.
Investors can do so by using a filter for both quantitative and qualitative attributes.
Strong companies have a defensible competitive moat that is not easily scaled by competitors.
They also tend to have great track records of growing their revenue, net profit and cash flow through economic cycles.
Most of the stellar companies have a strong brand or brands and command a dominant market share within their industry.
Quantitative factors will include aspects such as gross and operating margins, free cash flow generation, debt levels and the payment of dividends.
Once you have identified your ideal investment candidates, you need to decide how much money to allocate to each of them.
A general rule is to allocate more to companies that display stable and consistent characteristics.
For riskier businesses in cyclical industries, you can size these positions smaller.
Holding on for dear life
The next step is probably the hardest of the three.
And that’s to have the patience to hold on to a winning position as the business continues to grow and prosper.
This may seem like a simple task, but many investors can’t resist the urge to lock in a profit.
Another simple rule that I follow: Make a periodic check on the health of the business.
If the business continues to grow and the investment thesis remains the same, then it makes sense to continue owning it.
Great fortunes are made by people who have held onto their winning stocks over years, even decades.
You should fight the urge to book a profit because the secret to successful long-term investing is to hold tight to your winners as they continue doing well.
It’s important to have the right attitude when dealing with a winning stock.
Our mindset should be to always hope for the best (i.e. be an optimist) but to also expect the worst (i.e. be risk-averse).
Balancing these two attitudes requires an understanding of the future outlook of the business and any risks that may threaten to derail its growth.
But in my experience, if the company has been doing what it does best for so long, there’s very little you need to do by way of monitoring.
Compounding your dividends
The final, and arguably most crucial, step to enjoying stellar returns is to compound your dividends.
Compounding refers to the reinvestment of your dividends back into the very same stocks that paid out those dividends.
To provide an example, assume Singapore Exchange Limited (SGX: S68), or SGX, pays out an annual dividend of S$0.32 and that you own 10,000 shares of the company.
You will receive a total of $3,200 in dividends for the year, which you can then use to purchase another 300 shares in SGX (at a share price of S$10.00).
By the time the next dividend rolls by, you will own 10,300 shares of SGX and be entitled to receive around S$3,300 in dividends, S$100 more than the year before.
By rinsing and repeating this process over years, you can then accumulate a larger shareholding in the companies you own and also enjoy increased passive income.
The calculation above assumes that the dividend stays constant year on year, but that’s not the case for many great companies.
There are a handful of companies that have grown their dividends consecutively for a decade or more.
By harnessing the power of compounding in such companies, you can greatly accelerate the growth of your investment portfolio.
Get Smart: It’s simpler than you think
Investing needn’t be difficult or complicated.
The above steps show how you can go about enjoying great, long-term returns in a fuss-free way.
So what are you waiting for?
It’s time to start deploying your capital and growing your retirement nest egg.
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Disclaimer: Royston Yang owns shares in Singapore Exchange Limited.