Stock Investing for Beginners
Successful stock investing is a synthesis of four fundamental factors- understanding own risk profile, identifying right investment bets, understanding the trading environment…
Anand Mishra
Despite being a country with a higher savings rate, India is a poorly equity-penetrated country with just about 5 per cent of population investing in the equity market. For a population of over 1.2 billion, there are just a little over 20 million demat accounts and about 37.5 million mutual fund folios. Further, the market is highly concentrated with estimates showing just about 10 cities contributing over 80 per cent of trading volume (in 2010). In this environment, it is highly desirable that more and more investors enter the equity market and contribute to the growth of this market by adding liquidity and depth. This is the rationale of government efforts of last few years to encourage equity investment by providing tax benefits.
But investing in stock markets can be a daunting experience, even for the well-initiated and informed individuals, let alone a layman. The multitude of factors that are to be taken into account while deciding on investment is just too much for the uninformed and impatient investors. And these are the traits that a potential stock market investor should guard himself against.
Basically, successful sock investing is a synthesis of four fundamental factors. First, before taking the first step, one needs to understand one’s own investment profile. Second, one should be able to identify the right investment bets, read scrips in which one needs to invest. Third, one needs to understand the trading environment in which one operates. The fourth, and the most critical factor, is the need to be disciplined in investment behavior. These are the fundamental aspects that any investor needs to work on assiduously to make well-informed, well-timed and successful investment. We would elaborate each of these in some detail.
Knowledge is money
The first and foremost step of stock investing is understanding one’s investment profile. This is necessarily the first step because only after this understanding can one decide how much to invest, in which asset class to invest and in what proportion. Every investor needs to understand that equity investment has to be just one component of his entire investment portfolio, others being fixed income instruments, commodities, bullion and, of course, cash. For initial investors in the stock market, equities should ideally not be more than a quarter of their entire portfolio.
Equity exposure can come in three forms—namely, the direct equity investment in select stocks, equity-based mutual funds and exchange-traded funds (ETFs). Again, one should realize that because of professional fund management, mutual funds are better equipped to spread investment to reduce risk, that is, to diversify. ETFs, on their part, mimic the index and as such are microcosm of the broad market. After careful assessment, one needs to take a call on how much money one can place in equity MFs and ETFs, and how much in direct equity.
Once that is decided, investor needs to find out how risk he can take; this would determine the equity class. You may be a risk-averse investor, which means you would be happy to get lower returns if they come with low uncertainly or volatility. Alternatively, you may be a risk-loving investor, in which case you may want to go in for stocks that generate high return but with higher volatility.
The basic premise is simple: the more risk you take, the greater return you might earn. Sure, you can get very low returns on high-risk scrips and vice-versa, but these are exceptions to the rule.
Getting started
Once you have adequately mapped your risk appetite, you are much better placed to select the right scrip, which is the second aspect of successful investing. Here the task is to match the risk of the share with your own risk level. If you are highly risk averse, you should place your entire equity corpus in large-cap blue chip stocks that are in highly defensive businesses such as FMCG (fast moving consumer goods). Typical investment bets in this arena could be HLL or ITC. In case you love moderate risk, you may go in for shares in cyclical sectors, such as capital goods or financials. Good engineering companies such as Siemens, BHEL and large public sector banks like State Bank could be safe bets in this arena. If you are able to take even more risk, you can go in for midcap, small stocks or companies in emerging business arena like biotechnology or cloud computing application development.
Here, it is advisable that the initial investors should stick to the most liquid and the best representative stock in the selected category. So, some information gathering on parameters such as price earning (PE) multiple and stock beta for stocks in desired stock category or sector is highly advisable. The PE multiple tells you about how costly the scrip is relative to its earnings per share. Generally, the lower the PE ratio, the more attractive the stock is. Similarly, the lower the beta, the less volatile or risky the stock is. These are some of the most commonly used parameters one can look into while deciding on which stock to buy.
Finally, to lower the risk, one should try to diversify well. So, try to spread investment in stocks in more than one sector; two or three sectors are advisable. Even within a sector, one should try to put money in top two to three stocks. However, one should guard against over diversification because non-expert investors can not follow up or manage risk return matrix of a large portfolio.
How to do
But successfully identifying investments bets is not the end of investment; it is in fact the beginning. One should also understand the trading and settlement and stock holding mechanism. In India, we follow a T+2 rolling settlement, which means that the stock is added to your holding and payment is made on the second day after making a purchase. Similarly, your demat account is debited and money received two days after you’ve sold the stock. This cycle is very important to understand very clearly in order to be ready with the money and shares for settlement of trade.
The second issue is that of demat account and its management through depository participants (DPs). Since it is almost a given that you would have a demat account to hold shares in, it is important that your DP should be convenient to you. You should try to go in for a DP which has its office close to your home or office. Even though your interaction with DP would not be much and could be completely managed on phone, it is always comfortable to have DP at close quarter to manage problematic situations which can be quite baffling for initial investors. Then there is the aspect of cost. DPs charge three types of fees—namely, the annual maintenance fee, the custodian fee and the transaction fee. You must compare the charges that different DPs charge for your specific requirements. Finally, you must have a ready nomination for your demat account and also be aware of the process of transfer of shares between different DPs, in case you decide to switch.
The discipline
Finally, we come to investment discipline which must be observed in order to be a successful investor. Though these are true for all investors, initial investors should especially adhere to these time-tested principals. First of all, you need to understand that stock investing is a mid- to long-term commitment. Short-term or day trading is highly risky and, as such, should be left only to professional investors. The longer you stay invested, the greater is the chance that you would weather the small hiccups and exit with sound return. Second, you should not invest your entire corpus in one go; spread investment over some a period of time. This way you manage to tide over the short-term price aberrations and can expect to pick up stocks at their ‘right’ price. Third, you must not invest with borrowed money and not invest all your money in stocks, even if you are a seasoned investor. These are traps; even slight miscalculation or plain bad luck can push you very deep in the red. Fourth, stock investing is not lottery; extreme gains are possible, but are rare, so keep your return expectations within realizable limits. Past performance trends should be referred to get guidance.
Finally, be wary, very wary of ‘hot tips.’ Do not buy any stock without studying it in reasonable detail. Remember, stock investing is an art; even though it gives you ample scope for experimentation, there are basic rules to follow. As long as you play according to these golden rules, you would end up winner.
