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10 things investors should understand before investing in Equities.

Updated: Sep 26, 2020

1st July 2020

Dear Readers,

A little over two percentage of the Indian population invests directly in the stock market. In the more developed economies around the world this number jumps to forty percent. This scenario though, is changing quickly.

With the advent of internet brokers facilitating the investment process, mobile trading platforms, rise in disposable incomes, and better awareness of alternative investment opportunities more Indians are beginning to turn towards equity investments.

While Equity is a fantastic asset class to beat inflation and create wealth, it comes with its own risks. These risks can largely (though not completely) be mitigated by following sound investment practices. In this article we outline ten things investors should understand before investing in equities.

1.Equity investments differ from investments in Fixed income products.

Equity investments generate returns through capital appreciation & dividends. whereas fixed income products generate returns through regular interest payouts.

Fixed income products could include corporate debentures, government bonds, treasury bills, fixed deposits etc. They are designed to give an investor secure & periodic returns at a fixed rate with minimal volatility. They are essentially loans that an investor provides to a corporate, bank or the state on which he earns a fixed return.

Equities unlike the above represent ownership in a company. The investor by owing stocks of a company shares a part of the risk taken by the promoters and entrepreneurs running the company. When the company does well it creates value for the investor by paying out dividends and increasing the demand for its shares. This pushes up the share price. These shares may later be sold for a profit by the existing investors.

This is however a volatile process as the company may go through many ups and downs (sometimes beyond its control) during its tenure. This makes stock investments risky especially for those investors who do not invest with a long enough investment horizon (generally of at least 5 years).

In summary equity investments are not designed to give (in most cases) secure periodic returns at a fixed rate. Having said that, returns on equity investments in the long run have historically been much higher than those generated by fixed income products when careful due diligence is exercised while investing.

2. Equities may not be the right asset class for risk averse investors.

As discussed above the volatile nature of equity investments makes them a less ideal choice for conservative investors hoping to generate stable returns. An investor in equities could witness temporary (or in some cases permanent) losses on his investment portfolio. Moreover, Investing in equities by oneself may prove to be a laborious task requiring deep research and frequent evaluation of investments. This job is best left to fund managers who practice this as a part of their profession. Alternatively investing in a low cost index fund is the right approach to equity investing for most investors.

3. 'Equity investing' is not the same as 'Equity trading' (aka 'Stock trading')!

One may often find that the terms ‘Investing’ and ‘trading’ are used interchangeably. These are however two very different approaches to buying and selling equities. The difference primarily lies in the investment tenure and the investment process. Investing is a long term process spanning many years (sometimes even a decade! or more). It involves deep research and analysis of prospective investments (as discussed in point 4.) before the capital is deployed. Trading on the other hand is done over a much shorter tenure typically no longer than a few months (sometimes even a few minutes). The trades are often (if not always) leveraged, speculative & volatile. This form of investing pays minimal to no heed to the fundamentals of the underlying stock or investment. It is unsuitable for most investors owing to the risk and uncertainty associated with the trade. Research has shown time and again that equity investing has created far more sustainable compounding of wealth compared to equity trading.

4.Equity represents ownership of the company, it is not merely a ticker on the exchange.

It is often easy to forget that purchasing a stock represents the ownership of a company each with its unique set of opportunities, challenges, weaknesses and strengths. Deep research & Fundamental analysis are crucial for picking the right stocks and profiting in the stock market.

While investing in a company it is important to evaluate all the following factors thoroughly.

Its intrinsic value relative to its market capitalisation , to ensure an investor does not overpay for the company. Management ethics, to ensure all shareholders including minority shareholders are treated fairly by the promoters and the company does not run into legal trouble, which could severely affect the share price. Management quality, An experienced and well qualified management team is likely to be able to navigate better through the ups and downs of the economy. A long runway for growth, which ensures that the company is able to grow at a sustained pace. Competition and economic moat, to understand the unique advantages that help a company maintain its earnings and profit margins. The possibility of technological disruption, to ensure the company stays relevant in an ever changing market place underpinned by technological advancement.

So the next time an investor receives a ‘tip’, it could save him a lot of money by having a checklist in place to assess all the above factors, before investing his hard earned capital.

5.Diversification is a good idea, Over diversification is not.

Fund managers walk a fine line between maximising returns and keeping the portfolio adequately diversified. To understand the trade of it is important to first understand the meaning of systematic and unsystematic risk in the stock market.

Systematic risk refers to the risk inherent to the entire market, not just a particular stock or industry. Examples of systematic risk include the crash of 2008 or more recently the ongoing Covid19 pandemic.

This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification. Proper asset allocation into different asset classes may minimise this risk to some extent. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,” that affects the overall market,

Unsystematic risk can be described as the uncertainty inherent in an investment in a company or an industry as a whole. Examples of unsystematic risks include regulatory changes, technological obsoletion, entry of a new competitor, strikes, outcomes of legal proceedings etc. This risk is also known as diversifiable risk, since it can be eliminated by sufficiently diversifying a portfolio.

Higher diversification through the ownership of many stocks in unrelated sectors and industries reduces unsystematic risk. This however also minimises the returns on investment, as it is averaged over a large number of stock holdings in a portfolio. In other words the marginal benefit of diversification after a certain point reduces with every additional stock an investor adds to his portfolio.

From research we know that, if the risk associated with non-diversification (i.e. ownership of only 1 stock in the portfolio) is 100%, this risk drops to between 40% and 50% on the ownership of 5 stocks and to roughly 20% on the ownership of 30 stocks, post which the risk reduction is negligible and counter-productive.

6.There are many schools of thought regarding the right approach to Equity investing, each with their own benefits and drawbacks.

Value investing; Growth investing; Momentum investing; and more recently Behavioral Finance, are all various investment approaches to equity investing, each with their own merits and draw backs.

Value investing made popular by one of the greatest investors alive Warren Buffett is an investment strategy where stocks are purchased in companies that appear to be trading below their intrinsic value. Higher the discount, higher the margin of safety in the investment. The underpinning belief of this strategy is that the market often fails to accurately calculate the intrinsic value of a stock and its future earnings potential relative to its current price. The market also overreacts to good or bad news offering investors entry or exit into their desired stocks. While this strategy has proven to create enormous wealth for investors who are able to practice it accurately, it has its own set of drawbacks. New investors adopting this strategy may often get caught in a ‘value trap’, a company that seemingly appears to be trading under its intrinsic value but in reality has inflated its book or oversold its story to gullible investors. Also value investors often find themselves taking contrary positions to the market and the market may take a long time to realise the potential value in a stock, this delays a profitable exit for value investors.

Growth investing involves investing in companies that are expected to grow at higher rate compared to the industry, sector or the market as a whole. The stocks that growth investors seek are often expensive or overpriced compared to the current earnings or revenues of a company. They however hold the belief that these stocks have the potential to keep compounding their earnings at a sustained pace. When a growth stock fails, it often fails spectacularly as they are purchased at expensive valuations causing a large drawdown in the portfolio. The stock price is also quite sensitive to quarterly earnings releases and can drop sharply if the company fails to meet investors expectations.

Momentum Investing is a strategy that capitalizes on the continuance of a market trend. It involves using technical indicators & moving averages to determine the strength of a trend and base trades upon it. Momentum investing disregards the fundamentals of a company and hence is seldom used by long term value investors. This strategy is more relevant for traders who undertake leverage to invest in the markets.

Behavioural finance is a relatively new field which is gaining popularity amongst the investment community. It postulates that investors (human beings) are irrational and psychological influences and biases affects the decisioning making process that governs an investment. With information asymmetry becoming a thing of the past, this set of investors claim that a behavioural edge is perhaps a better indicator of success in the stock market over the long run. A behavioural edge can be gained by understanding and manipulating ones own biases while making an investment in a stock. This very fact makes this style hard to adopt as it involves manipulating ones own behaviour and biases which can often times prove to be quite difficult and un-natural.

Most investors combine two or more styles discussed above to create a portfolio of equities.

7.The stock market cannot be predicted!

This is perhaps the most important aphorism for an investor to accept before stepping into the temple of the stock market.

There has been no computer, human or AI developed till date that can predict the stock market with a reasonable degree of preciseness or accuracy which makes investment or trading consistently profitable. All predictions are merely speculations with varying degrees of probability of occurrence based on the underlying assumptions. By and large the markets are believed to follow a Brownian motion where the assets are continuously changing over very small intervals of time altered by random variables that cannot be accurately predicted.

Accepting the above belief bestows humility making an individual a better investor over the long run.

8. ‘Time in the market’ is a much better predictor of success than ‘Timing the market’.

The single most important edge an investor can gain versus the rest of the market is by prolonging his timeframe of investment. Equity investments become significantly less riskier when held over a long investment horizon. This is perhaps best explained from the illustration below.

An investor who stayed invested grew his wealth at 14.5% CAGR over the last 30 years. Roughly 58x on his original investment. He achieved this despite scams, crashes, bubbles, currency depreciation, terror attacks, natural disasters etc., none of which could be predicted. If these cannot be predicted, then what good does timing a market bring an investor? At best, one may be right half the time and wrong the rest.

9. Over leverage kills.

Not too long ago investing in the stock market had many negative connotations associated with it. Stories of people losing all their money in the stock market had become common hearsay. Now, strictly speaking it is hard to lose all of ones money in the stock market unless one is leveraged and follows no diversification strategy for their portfolio.

Today access to leverage has become easier than ever, brokers offer 7 to 10 times leverage (sometimes even more) on bellwether indices such as the Nifty. This implies a 10% movement in the index could essentially wipe out or double an investors portfolio. Far more money has been lost this way than by investing in a few wrong stocks in a well-diversified portfolio. So most risk that people (often unknowingly) talk about comes from indulging in derivatives such as futures & options (selling) with the aim of making quick money. Derivatives should only be used to hedge positions and leverage should ideally be limited to a maximum of 1.25 times the principal investment.

10. Equity investing has the potential to create tremendous wealth if done right.

Equity investing has produced many successful investors who have amassed a large fortune in the markets for themselves and their shareholders. Warren Buffett (Berkshire Hathaway), Charlie Munger (GEICO), Peter Lynch (Fidelity Investments), Jhon Bogle (Vangaurd Group), Ray Dalio (Bridgewater Associates), Radhakishan Damani (Dmart), Rakesh Jhunjhunwalla (Rare Enterprises), Vijay Kishanlal Kedia (Kedia Securities) are a few examples that represent the pinnacle of success in equity Investing. A feat that no real estate, bond, precious metal or commodity investor has been able to achieve.

While the goal may seem daunting, it helps to remember that all large corporations (Reliance, HDFC, Bajaj, TCS, Infosys, Titan etc.) were all small caps at some point in time with their shares quoting in the single digits! The next set of potential large cap stocks have already been listed on the exchange, our job as investors is to find them, study them and invest in them for the long run.

SEBI Disclosure: This report is not a recommendation to buy or sell any stocks or provide investment advice. Investors are requested to conduct independent research or consult their Registered Investment Advisors for advice. Prosperity Wealth Management Pvt. Ltd. will not accept any liability for any investment decisions made based on this report. Prosperity Wealth Management does not guarantee the accuracy of any information provided herein. Copyright 2020. Data source: Investopedia, Motley Fool.

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