Do you know how stock market works? More accurate is your understanding about stock market, wiser will be the investment decisions.
In 2008, SENSEX fell from 20,000 levels to 8,600 levels in span of 12 months. On March’2009, SENSEX touched the bottom of 8,563. By June’2009 SENSEX regained the position of 14,700 points. The investors who invested in March’2009, saw their money grow by 70% in span of just 4 months.
But what happened after that? Between June’2009 to February’2014 SENSEX ran nearly flat. In February’2014 SENSEX clocked 20,300. The investors who invested in June’2009, saw their money grew just at the rate of 7% per annum in span of 4.75 years.
Subsequent to February’2014, SENSEX jumped to 29,500 points in next 12 months (Febriary’2015). The investors who invested in February’2014, saw their money grow at rate of massive 45% per annum in span of 1 year.
After February’’2015, SENSEX again fell to 22,600 levels till February’2016.
From February’2016, SENSEX rose again to 28,500 levels till September’2016.
From Spetember’2016 till December’2016, SENSEX is again nose diving from 28,500 levels to 26,300 levels.
In last 7 years, the stock market index has only confused the short term investors.
But it is not the same for long term investors. In last 7 years, SENSEX has grown at CAGR of +17% per annum. In last 5 years, SENSEX has grown at CAGR of +10% per annum.
It is sure that it will take lot of guts for short term investors to invest now in stock market. The market movements has been extreme in last 7 years. This is one reason why, small players are feeling very unsettled in stock market. Since the aftermath of 2008, the stock market has become very unpredictable.
But is this phenomenon a one off case for stock market?
No, stock market is actually behaving (since last 7 years) the way it has always behaved. These ups-and-downs in SENSEX are normal. Expert call it market cycle. People who are aware of this cyclic behavior of stock market do not give unnecessary weightage to this volatility.
A person who keeps watching his portfolio twice everyday, is sure to get panic attacks. But people who have left their investments alone, giving it time to perform, are big gainers. The best advice about stock investing can be, invest your money and do not touch it for next 5 years. This is the smartest investment strategy. By investing passively, one can probably make more money that the experts.
It is common to feel confused when the market is playing very volatile. In such circumstances, it is better not to touch your portfolio. Instead, in those times its better to get hold of good books on stock investing. Brushing-up ones stock investing skills will be a great idea during tough times. But make sure that the investment portfolio remains untouched when stock market is going south.
In this article, we will try to put-forth few basic facts about the stock market that all investors must keep in mind while investing in stocks.
Introduction to Stock Market Investing
Children like to eat chocolates. Given a chance, every child would like to own companies like MARS INCORPORATED (who makes, M&M, SNICKERS, GALAXY etc), MONDELEZ INERNATIONAL (who owns Cadbury) ec.
But is it possible to own such companies?
MARS INCORPORATED is a $33 billion company in revenue. MONDELEZ INERNATIONAL is a $29.6 billion company in revenue.
It is impossible for even an adult to own such companies, let alone a child.
But stock market allows one to own a very tiny fraction of these global giant companies. This way stock market allows anyone to become tiny owners of any company. When a person own shares of any company, he/she is passively participating in companies business.
If company will grow, shareholders make money. If company is losing, shareholders will also lose money.
It means that, when one invests in stocks there is possibility to both gain or lose money. This is what makes stock market investing risky.
But why at all any company will not grow? Companies which do not have strong business fundamentals are more likely to lose money.
Even when fundamentals of companies are stable, still its market price can fall, majorly in short term. This happens due to external factors like economy.
What are these external factors?
Like in 2008, price of Indian stocks fell down due to financial meltdown in USA. Similarly, when BJP came to power in March’2014 in India, Stock market (SENSEX) jumped close to 9,000 point in 12 months.
Investing in stock market means buying stocks of companies. This way, the money of investors are held in stock market. When the person wants to take his/her money out of the market, he must sell the shares.
The point of selling is very important for any investor. Suppose a person bought a share at $10. It he will sell the same share at $9, he is losing $1. If he will sell the same share at $12, he is making $2. So the right time to sell shares is when the market price is above the price at what that stock has been purchased.
Times when SENSEX is moving up, is the most likely times when person should sell its share holdings.
Times when SENSEX is moving down, is the time when person should be either holding or buying more shares.
What are stocks?
When a person says that he has a ‘stock’ in APPLE INC, he is indirectly saying that he has a ‘piece of ownership’ in APPLE INC.
Why company sell its stocks in stock market? All companies generates operating cash flow in two ways, from its ‘reserves’ (accumulated profit) & by borrowing ‘debt’. But reserves and debt is often not sufficient to fund major expansion plans.
To fund major expansion plan of companies, it needs huge cash. This cash can be generated by taking loan from banks. The cash can also be generated by issuing stocks.
Big companies prefer issuing stocks. As stocks represent ‘part ownership’ in a company, hence payment of compensation to stockholders (in form of interest/dividend) is not mandatory. But in case of debt, company is obliged to pay interest to the issuer (issuing bank, NBFC etc).
How the stocks are priced? The main factors that decides market price of stocks arr: (1) net worth per share & (2) earnings per share of the underlying company. All other factors within the company ultimately contributes to increase/decrease companies net worth & earnings.
Ideally company which has net worth per share of $10 should be priced higher that a company whose net worth per share is only $5.
Similarly, company whose earning per share (EPS) is $2, should be priced higher than a company whose EPS is $1.5.
But this is only a rule of thumb. Actually price of stocks vary between sector to sector.
Suppose there are two stocks, A & B. Company A operates in Auto sector. Company B operates in Oil & Gas. EPS of A is $2. EPS of B is $1.5.
Average Price Earning Ratio (P/E) of complete Auto Sectors is say 22. Similarly, average Price Earning Ratio (P/E) of complete Oil & Gas Sectors is say 35.
In this case, the stock price of A will hover around $44 (EPS X PE = $2×22). The stock price of B will hover around $52 (EPS X PE = $1.5×35).
Favorite sectors of investors tend to have higher PE ratios. Non preferred sectors by investors tend to have lower PE ratios.
Sectors which are preferred by investors will have more demand for its stocks. Sectors which are less preferred by investors will have lesser demand for its stocks.
Hence we can conclude that, in addition to companies fundamentals (net worth, EPS etc), it is also the ‘ demand’ of stocls that dictates market price of stocks.
I personally consider that, in long term, the influence of business fundamentals on market price of its stocks in 65%. The influence of ‘demand’ on market price of its stocks in only 35%. But in short term this relation flips between each other.
How companies raise funds using Bonds?
‘Bond’ is another very effective way companies can raise funds on its own. To raise funds using bonds, like stocks, companies can do it without being dependent on banks & NBFC.
But the problem with Bonds is that, there are comparatively less takes for bonds. Unless a bond is issued by G.O.I or a very reputable business house like Tata, Reliance, Jindal, Banks etc, there are less takers?
Why? The reason being, bond is like a fixed income investment for the investors. The interest earned on bonds is close to what banks offer in their FD’s.
From point of view of investors, when returns are not so high, why to go for bonds? People will prefer bank FD’s or debt linked mutual funds.
But its is also a fact that, when big, stable companies offer bonds, there are many takers.
How Bond work?
When one buy bonds of a company, it is like lending ones money as a loan for a specific period of time.
After the end of the bond’s tenure, the invested money (principal) is returned back to the investor. While during the bond’s tenure, fixed interest (coupons) is also paid to the investor as R.O.I.
Like bank deposits, Bonds are also risk-free investment option.
If investors do not want to take risk, where he can invest money?
Stock investing is most risky. Volatility of market price, change in business fundamentals, effects of surrounding economy, lack of knowledge etc makes stock investing risky. But people who know to manage these variables can make lot of money in stocks.
Similarly bonds are also risky. But they are not as risky as stocks. As bonds are issued by companies, they cannot be considered 100% safe.
What an investor can do if he wants to invest money but without taking risk?
Risk free investing is possible. But the lower will be the risk, lower will be the returns.
This is why stocks can give higher returns (14% per annum) than bonds (10% per annum), because stocks are riskier than bonds.
But there are investment options which are risk free. In financial terms we call them cash-equivalent investments.
Why cash-equivalent? We keep cash in banks savings account, how must interest we earn on them? About 4% per annum. For sure the interest earned (compared to inflation) is very less, but savings in bank account remains most safe.
Savings in bank account are also very liquid. A person can go any time to ATM and withdraw the savings.
But stocks or bonds are not liquid. Fixed income securities like bonds, in fact has locking periods. If a person withdraws the money prematurely, penalty is imposed. But in cash-equivalent investment, liquidity is 100%.
Similar to savings account, there are options like Fixed Deposits, T-Secs and Money Market Mutual Funds which are called cash-equivalent investments.
Why mutual investing should be preferred
A typical mutual fund portfolio can be composed of a combination of assets. They can include stocks, bonds, cash-cash equivalent investments all together.
Depending the type of mutual fund, a fund may carry 100% stocks. These type of funds are called equity funds.
A mutual fund may carry in its portfolio only bonds, deposits, T-Sec, cash etc. These type of funds are called debt funds.
Some mutual fund may carry in its portfolio only cash-cash equivalent assets. These type of funds are called money market funds.
Mutual fund may carry in its portfolio a combination of stocks, debt & money market instruments. These type of funds are called balanced funds.
Mutual fund companies invest money on our behalf. They first approach the public and inform them about their mutual fund (like HDFC Top 200). If the investors gets impressed by the mutual fund, they buy mutual fund units.
Like this, several investors from across the world buy mutual fund units of say HDFC Top 200.
The money collected like this are called “pool of funds”. The money pooled like this, are then invested by the fund manager depending on the ‘funds objective’.
In last couple of decade, mutual fund India has sky rocketed in India. Perhaps no other financial instrument has attracted more investors than mutual funds during this period.
Why mutual fund are so popular among public?
Mutual fund provides the most customized investment diversification for its investors.
Even if people buys a equity mutual fund, they are still buying a fraction shares of many companies. Holding shares of only company may be risky. But when holds shares of many companies, the risk of loss is greatly minimized.
If a person buys a balanced mutual fund, he/she is actually buying a share of a portfolio which has stock, bonds, money market funds etc. This provides even better investment diversification than equity mutual funds.
On top of this, the person who manages mutual fund (Fund Manager & Team) are professionals. They have not only education qualification but also aptitude and experience for investments.
This team is also backed by a research and analysis based collection of market data (which is not accessible for us).
This are some factor that gives a definite edge to mutual fund companies over individual investing.
Mutual fund investing is convenient for common man. One can buy a mutual fund unit and relax. The pain of collected of market data, does research and analysis, portfolio creation, selling etc are all done by the mutual fund manage and the team.
What is the best investment strategy for common men
These investment strategies are core to any investment. No matter how good or bad is the market, if one will follow these strategies, in long run, above average returns are sure.
Keep investment portfolio well diversified
Warren Buffett buys companies. If he cannot buy companies, he buys its shares worth thousand of dollars. This way he is actually not diversifying. Instead he is putting all eggs in one basket.
If Buffett is doing so, why we must keep our portfolio diversified?
Lets take this example. Suppose you want to buy vegetable. You go to market, and then pick and choose the best vegetable. The vegetables which looks fresh are preferred. The vegetables which are expensive are left.
But can we do the same with stocks? Do we have the skill to identify stock of good companies? Do we have the skill identify expensive stocks? In most cases the answer is no.
It means, we are actually buying stocks without knowing about it. Hence experts tell us to buy different stocks. If some are bad, some will also be good. It pure luck.
But Buffett is no ordinary man. He is perhaps the best man of this earth who can (1) best identify good companies & (2) also know its best price.
The more one becomes knowledgeable in judging companies, lesser he needs to diversify. This is because, he has left least on luck. He is actually SURE of his future earnings.
But when is not sure of the future earnings, diversification becomes the best gamble.
You can buy a balanced mutual funds for best investment diversification. Index linked funds or ETF’s are also best for diversification.
Invest with right time horizon
Some investment options are are suitable for shorter time horizons. Some investment options are are suitable for longer time horizons.
People often make the mistake of buying stocks for shorter time horizons. People also buy debt linked plans for longer time horizons. This is a mistake.
Out of all the fundamentals of investing money, knowing the right time horizon linked with each investment is the most basic.
But why knowledge of time horizon is so important?
Suppose one is investing for 15 years period and buy a fixed deposit. In this time horizon the best returns can earn is 7-8% per annum. For such long time horizons equity linked investment options are the right choice.
In fact, when investment horizon is more than 5 years, one must choose equity (direct stocks, equity mutual funds etc). In such longer time horizons, the returns of equity is almost as assured as debt.
Suppose one is investing for 2 years period and buy stocks. In this time horizon there is no certainty that stock price will go up. For such shorter time horizons, debt linked plans are better. The returns are surer.
In this time horizon there is no certainty that stock price will go up. For such shorter time horizons, debt linked plans are better. The returns are surer.
Suppose one is investing for 6 months period and buy bonds. Though returns of bonds are assured, but it has longer lock-in periods (like 3-5 years). If bond is liquidated before this maturity period, penalty is imposed.
Hence, even though bond is like risk-free investment, but wrong time horizon will make it a bad choice.
As a rule of thumb, equity needs longer time horizons to give higher returns.
Selection of right investment option is heavily dependent on when the invested money is required for use. Suppose one needs the funds after 1 months, better to invest in savings account.
If one needs the funds after 1 year, better to invest in cash-cash equivalent options.
Buy balanced mutual funds, when funds are required after 3 years.
Consider buying equity mutual funds, when funds are required after 5 years.
Buying stocks is perfect when funds are required after 10 years.
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