Investing into stock markets

Stock markets are an enigma to those who stay away from it as well as to those who are into it. But what attracts people to stock markets, despite the market's risk pervasiveness, is the prospect of returns.


However a wast majority of people in India are not invested in stock markets. A study conducted in 2009 indicated that only 8 million investors out of a total of 188 million that hold financial assets have a direct or indirect participation in the stock market. This is in the backdrop of an 18 times rise in the Bombay Stock Exchange's 30-share index-the sensex-over the span of three decades as well as tax benefits that favor stock market and mutual fund investments over other fixed income investments.   


The financial planning way of investing advocates an exposure to equity and equity linked investments in all stages of one's life, including post retirement-- only the allocation may vary. It focuses on first ascertaining an optimum asset allocation to equity, something that Certified Financial Planner professionals do by risk profiling an individual with respect to the chosen financial goals. The investment made directly or through the mutual funds by the way of Systematic Investment Plan (SIPs) provides various benefits, including the risk diversification. The disciplined investment approach recommended by a qualified CFP practitioner in sync with an individual's financial goals also irons out adverse aspects of behavioral finance, such as under-reaction or over-reaction to information. 


Stock market indicators or stock indices basically reflect a country's corporate health with regards to earnings and the growth prospects of companies. This micro aspect is influenced by factors touching every little aspect of the economy and international events. Therefore, markets reverberate to absorb the impact of whatever affects corporate earnings-factors that range from macroeconomic, political to geo-political. This is why stock markets are called the barometer of economic health and stability of a country or region.   


Sensex has given a return of 17.6 percent per annum since its inception. However,this return is not with out its proportionate element of risk. the rise has been volatile enough to to shake the confidence of even die-hard investors.  the table (on the following page) gives a picture of returns calculated from various strategic points in the sensex journey.
As it has been observed, long-term returns from stock markets are significant and effectively beat inflation.  short-term returns are volatile. Investing in times of euphoria has its pitfalls in huge capital losses. The sensex had lost 50 percent within a year from the then peaks reached in 1992 and 2000.


Investment discipline is, therefore underlined over adventurism or trying to trade the market against the collective wisdom of millions of investor,traders, domestic and foreign institutional investors.


The history of the sensex as well as the world's major stock indices warn us to cover adequately the risk of value correction as well as time correction when market moves sideways for painfully long periods. Japan Nikkei Index touched a high of 38915 in 1989 but has steady lost 82 percent in the two decades since. The US Dow Jones  Industrial Average reached 11,000 levels in May 1999, but is just at 12,000 levels now. 


Stock market investment is good from long term perspective. Such investment helps the economy, too, as the Government's burden if fueling growth is shared by the private sector. Moreover, companies tapping capital markets display better transparency and corporate governance. Long term investment in stock markets also assimilates tax benefits on the capital gain. However, in th e proposed Direct Taxes Code (DTC), an investment asset held for more than a year in which it is acquired shall be allowed a specified deduction, the balance gains being taxed at rates being applicable to the tax payers. 


A disciplined approach to stock market investing calls for fixing a rate of return (say, between 15 to 20 percent), monitoring investments periodically, and suitably shifting excess returns achieved to debt investments to lock in the wealth thus created.  

Why do companies issue stocks?

Stocks represent individual's ownership within a company. One of the reason why a company issues stocks publicly is to raise large amounts of capital quickly. At some point of time every company needs to "raise money" to be able to expand their business. One way they can go is to either borrow it from somebody (probably bank, taking some loan) or raise it by selling part of the company, which is known as issuing stock. 


Issuing corporate bonds could be another way of raising money  but it has some limitations as bonds must be repaid at interest. Money raised by the issue of stocks is never repaid.Taking loan from the bank or issuing bonds for raising money is called "Debt Financing" on the other hand, raising money by issuing stocks is called "Equity Financing". From the company's point of view, equity financing is good as they don't have to repay the debt amount to their investors nor do they have to pay the interest amount.


All the shareholders buy these stocks (equities) in a hope that, someday the stock prices would go up (as company would grow over the period of time) and its value would be worth more than what they had paid initially. However this assumption may or may not turn out to be true. The first sale of a stock is done via initial public offering (IPO). 


As an investor, it becomes critically important for you understand the difference between a debt financing and equity financing. In debt financing (for example buying bonds) gives you some kind of guarantee (unless company goes bankrupt) that your principal amount is safe. You also get promised interest payments on regular intervals.Now when you as an investor are entering into equity financing (i.e buying stock from a company) , it becomes a different ball game altogether. Lets understand that "Thre is nothing guaranteed here in equity". You assume the risk of the company not being successful and you may end up loosing your capital. Usually shareholders earn a lot of money if a company is successful in their business, but they are also at the risk of loosing their capital if the company is not able to perform.


Having said these, it becomes very obvious question that what makes these stock prices rise and fall? If we can master this, we will know which stocks to buy, and which stocks to keep ourself away from. In the next post I will try to explain what makes stock prices go up and down.

What are stocks ?

The stock market appears in the news every day. You hear about it whenever it makes a new high or touches a new low...You hear statements like, Sensex rose today by 300 points.


Obviously, stocks and the stock market are very important, but do you really know  enough about stock market ? What are stocks? Why do we need stock? Why do people buy and sell stocks? What is Sensex, Nifty, BSE, NSE ??? If you have questions like these, this article is for you. 


So What does it literally mean when you purchase stock of a company? Basically it means that a stock holder is a owner in the company it holds stock in. As an owner, you are entitled to your share of the company's earnings as well as any voting rights attached to the stock. Stock (shares, equity or stocks, they are all same) represents a claim in a particular company's assets and earnings. When you acquire more stocks of that company, your ownership in that company increases. 


These stocks are traded (bought and sold) on stock exchanges. The two major stock exchanges in India are Bombay Stock Exchange (BSE, also knwon as sensex) and National Stock Exchange (NSE, also known as Nifty). 


Ok, that sounds great, but how do I own an stock of a particular company? Usually stock is obtained through a stock broker. Now a days trading and/or 
investment in stocks has become quite easier as most of the stock brokers like sharekhan, icicidirect, indiainfoline etc are having their online presense.


Let's say you want to buy stock of TataMotors . Either You can call the stock broker to place the order for you. When the TataMotors stock is purchased, the broker would keep a stock certificate that shows that you are the legal owner of the stock until you choose to sell it. However due to online presence of most of the stock brokers these days, you can place the order by yourself by going to their website. Trading with a click of the mouse or a phone call makes 
life easier for everybody.  Of course you must have DMAT account before you can buy/sell stocks of a particular company.


Being a shareholder of a public company does not mean you can interfere day-to-day business activities of that company. The extent to which you can interfere is 1 vote per share to elect the board of directors during the annual meetings. For example, if you have purchased equities from TataMotors, it does not mean that, you can call Ratan Tata to tell him how to do the business. 



What are the advantages of owning stock? 


We usually buy stocks of a company in an anticipation that its price would go up over a period of time. As company grow, so does the stock and its price goes up. Also, many investors can potentially benefit from the dividends on stocks that are issued by the company to  Conversely, when the performance of the company goes down, you may receive lower dividends or the price of the stock may decrease. If companies goes bankrupt, you may end up loosing your entire capital as well. 


One extremely important feature of stock is "limited liability" which means that, even if the company (whose stock you are holding) is not able to pay its 
debt, you will not be personally liable for that, because your liability is limited and only thing you will loose is stocks. 

What are bonds and how to evaluate them?

Bonds are usually debt instruments that are being issued by companies, governments and municipalities to raise funds for financing their capital expenditure. 

Bond issues are considered fixed income securities because they impose fixed financial obligations on the issuer. The issuer agrees to following terms :


(1) Pay a fixed amount of interest periodically to the holder of the bond
(2) Repay a fixed amount of principal at the date of maturity 


So essentially, in bonds, an investor loans money for a fixed period of time at a predetermined interest rate.While the interest is paid to the bond holder at regular intervals, the principal amount is repaid at a later date, known as the maturity date. While both bonds and stocks are securities, but the important difference between the two is that bond holders are lenders, while stockholders are the owners of that organization whose stock they hold.


Different types of Bonds


(a) Government Bonds : Governments need funds for various developmental projects. Further, the government also needs to raise money to finance the fiscal deficit. In order to achieve the above goals, government usually issue bonds, so called  government bonds. The government bonds can further be classified into 3 types based on their maturity period. Bonds having maturity period less than 1 Year are called Government Bills. Bonds which have maturity period up to ten years are called Government Notes, while those bonds whose maturity period exceeds 10 years are called Government bonds.


(b) Municipal Bonds : These are debt securities usually issued by the state government and their agencies. 


(c) Corporate Bonds : When companies need to raise funds, they issue debt instrument, what is known as corporate bond.



Bonds have a fixed face value, which is the amount to be returned to the investor upon maturity of the bond. During this period, the investors receive a regular payment of interest, semi-annually or annually, which is calculated as a certain percentage of the face value and know as a 'coupon payment.'



Evaluating Bonds


While evaluating bonds, people must understand the term ‘coupon rates’ – which denotes the percentage of interest that the bond will earn for its holder. You can compare coupon rates of various Bonds, certainly the bonds that fetch the highest returns can give you good returns over a period of time. While 
evaluating bonds, the investor must consider the maturity date by when the bond can be redeemed.


Each Bond has its own call provisions and it is necessary to study them as an early pay-off on the Bond may entail loss of interest. The investor should also consider the reliability & reputation of the issuer of the bond as the investor may loose the entire investment if the issuing company files for bankruptcy.


A prudent invest will always diversify his/her investment in bonds by not placing all eggs in one basket. Buying bonds from different issuers may also be a great idea which will not only reduce the risk factor, but also fetch handsome profits.

In short, the prospective investor must thoroughly evaluate the schemes to derive optimum benefits.