You either get excited (greed) or scared (fear) when you think of equity (shares/ mutual funds) as an investment product. Let us try to understand the mystery surrounding this investment option.
You have heard or experienced the following about equity investments:
~ Returns can be made quickly in the stock market.
~ People can lose a lot of money in stocks.
~ Stocks are a very risky investment.
~ To make money you need to continuously buy and sell shares.
~ To make money in equity you must invest for the long term.
Let us try to understand why a lot of successful investors say that equity investments are for the long term. This is how the long-term approach to investing works:
Take for example any standard blue chip company (maybe the company you are working in). Find out what could be the annualised growth rate of this company for a period of at least 5 years.
A person who understands macroeconomics will be able to tell you that majority of the best companies in the country (assuming the current economic growth) will grow at a sustainable rate of around 15-20 per cent every year for the next 10 years and maybe around 12-15 per cent after that.
Hence if you own part of these companies the value of your investments can grow at the same rate at which these companies grow. Remember that in an ideal situation the net profits and share price of a company are directly related. If profits increase, share price goes up and vice versa.
If you have understood this then making money in the stock market is not very difficult in the long run. It is only a matter of finding the companies that will grow at 15-20 per cent for the next 10-15 years and be invested in them. Here is the role that a specialist can play -- identify the best companies which can continue at 15-20 per cent for the next 10-15 years.
Why do people lose money in the stock market?
1. Investors need to keep track of the company that they are invested in. If there is some reason due to which the company may not be able to survive then you should not be a part of that company. But if you still continue to own part of such a company then you lose your money.
2. There are a lot of people who trade in the market. Take an example that a person has Rs 10 in her/his pocket. S/he buys and sells shares on the same day. Assume that s/he is allowed to buy shares worth Rs 100 even if s/he has Rs 10 with him. This is called leverage. With Rs 10 in your pocket you are busing/selling shares worth Rs 100. That gives you a leverage of 10.
The stock market being a dynamic place the prices of shares go up or down. Take for example that the share price goes down by 4 per cent by the end of the day. Now if you had shares worth Rs100 which has gone down by 4 per cent you suffer a loss of Rs 4.
That is, from the Rs 10 in your pocket you have to pay the Rs 4 loss. Hence you have lost 40 per cent of your capital in one day. This is what happens to most traders who use leverage for trading. And this is why you have heard stories of investors who have lost everything in the stock market.
Why do markets go up and down?
There are unlimited reasons for this. Let me throw some light on this. You all have heard that the 'Economy is booming' or 'There is a recession'. What it means is that the economy is either doing well or it is not doing well. If the economy is doing well then the growth rate of companies is very high (maybe 20-25 per cent annualised).
Hence people feel that if they are part of this company then their money can grow faster. Hence more and more people start to put more money in such companies. Hence the market value and the share price of these companies goes up. Such a phenomenon is called a bull market.
Similarly, if people feel that there may be a recession (leading to a drop in profits of companies) then the value of such companies goes down (bear market).
But it is a fact that good times or bad times never last forever. Hence the markets always go up and down.
The author is a Pune-based specialist in financial planning.