Stock Market Basics

Stock Market Basics

How do I learn about stock markets? Are stock markets suitable for me? How can I invest in stocks? What shares should I buy to get the best returns? What is the best way to invest in stocks? Is investing in stocks equivalent to gambling?

The world of finance can seem like a complex maze to most people. Making decisions about investments, financial planning and understanding all the available options can be overwhelming to say the least. Most of us want to invest and watch our money grow over time, but taking that first step is always the hardest. The vast array of products, schemes and options available is also not helpful in the decision-making process. For most people, one of the most confusing aspects of investing is the stock market, also sometimes called the share market.

What is the stock market?

In the simplest of terms, the stock market is a place where you buy/sell shares of different companies.

What is a stock or share?

The stock or share of a company is an instrument that represents a fractional ownership of the company. In simple terms, a stock is nothing but a certificate that grants you part ownership of the issuing company’s business.

Buying a share of a company lets you to become an owner of the business. If the company grows its business over time, the value of your ownership, and the price of your shares, also increases.

Let’s say that there is a private company ABC owned by Mr. Promoter. He is currently the sole owner and owns all of its shares. ABC is doing very well and needs funds to expand its business. Typically, there are two options to raise those funds. The first option is to take a loan from the bank. The bank will charge ABC some interest on the loan and, as the business grows, ABC will pay back the interest and principal from its business income. This option is commonly referred to as debt.

The second option is for ABC to issue new shares to outsiders, either a few select investors or to the general public. If it sells shares to the general public, ABC is no longer a private company. It becomes a public listed company with shares listed and traded in the stock market. Mr. Promoter will now be a part owner of ABC along with hundreds or thousands of other people who buy those shares. The process of issuing new shares and getting listed in the stock market is known as Initial Public Offering, or IPO. This second method of raising money is known as equity.

The technical reasons that decide whether a company raises fresh capital through debt or equity are outside the scope of this article, but there are pros and cons of both methods.

What is stock price?

The price at which you can buy/sell a single share of a company is called stock or share price. It is important to remember that the price, by itself, is not indicative of the value of the company. A company with a great business can have a stock price of 20 while a company with an underperforming business can have a stock price of 2,000. But when used in conjunction with other factors, the stock price is a very important number that helps decide whether a company is worth investing in or not.

Technically, you buy a share at the offer price and sell it at the bid price. But for most practical purposes, the bid and offer price are very close. At any given point in time, there are thousands of people buying and selling shares of different companies. People who want to buy a share can either quote a bid price at which they want to buy it (bid price of the limit order), or simply buy the cheapest price at which someone is willing to sell it (market order). Similarly, people who want to sell a share can either quote their offer price (limit order) or sell at the highest price that someone is bidding for their shares.

Stock exchanges have all the necessary systems in place to match buyers and sellers of the same stocks to ensure that each and every participant’s orders get fulfilled as per the predefined rules of the market.

Please note that stock price must not be confused with the face value of a share. Face value is a completely useless number which indicates nothing about the stock or its valuation. In fact, most stock exchanges do not have the concept of face value at all.

What is market capitalization, or market cap?

Each company has a fixed number of shares issued at the time of incorporation. In order to raise money through equity, they can either sell a part of the existing shares or create new shares. This process can be repeated any number of times depending on the company’s financial requirements.

The total number of shares outstanding for a company multiplied by its latest share price gives the value of the total equity of the company. This is also called the market capitalization, or market cap in short. Shares outstanding includes the shares that are held by the company and its promoters. Free float is the number of shares available to the public for trading.

What is a stock exchange?

A stock exchange is the place where a company lists its shares for trading. India has two major stock exchanges, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). Majority of the large companies are listed on both exchanges and their shares can be traded on either one.

What is an index?

A stock market has thousands of listed companies. Most of these companies are traded every day which means that their prices change frequently. In order to gauge the trend of the overall market, or a particular segment of the market, indexes were created. These indexes are nothing but baskets of stocks that represent the segment which the index is targeting.

For example, the Nifty 50 Index is a broad market index that consists of the largest fifty companies listed on NSE. It aims to gauge the overall trend of the stock market. When someone says that the market is up 1% or down 2%, it usually refers to the change in the index value of Nifty 50.

What are the benefits of investing in stocks?

Since there is unlimited potential for any business to grow, the value of your investment also has unlimited scope for returns. Of course, that doesn’t mean investing in stocks can make you rich overnight. On the contrary, it takes a lot of work and patience to invest in the right stocks and for them to grow over time and generate profits.

One of the biggest advantages of investing in a business is that you are quite literally putting your money to work for you. That is also one of the reasons why stock markets give better returns than any other investment like gold and real estate over long periods of time.

What are the risks of stock investing?

"You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in markets." – Peter Lynch

There are two important types of risks in stock investing.

  • Systematic risk – There are a number of factors that drive the overall market. Geopolitical events, foreign investments and macroeconomic news are just a few examples. Although there are thousands of independent companies in the stock market, with different businesses and future prospects, but their stock prices move up or down in tandem nearly 70-80% on average. This is also known as systematic risk. No matter which company’s shares you buy and how those businesses are doing, if the overall stock market is falling, their stock prices would also fall. Similarly, even bad businesses might gain in value when markets are rallying.

  • Unsystematic risk – This refers to the specific risk of investing in a business. Even though a company may have excellent track record and past performance, but there is a risk that some change in the future might adversely affect its growth. Increased competition, changes in regulation, poor management decisions, etc. would result in a good business turning into a bad one.

Should you invest in stocks?

It is crucial to understand one thing when it comes to any investment. It is impossible to earn higher returns without taking extra risk with your money. The questions that you must always ask yourself are –

  • Is the risk/return ratio favourable?

  • Are you comfortable taking that much risk with your money?

The risk-free return refers to the interest you can earn on your money without taking any risk. In practical terms, you can consider a bank fixed deposit or a loan to the government as a risk-free investment. In India, the risk-free rate for medium to long-term investment is roughly 7-8% for most individuals.

Why is it important? In order to judge the quality of any investment, just ask one simple question – what is the risk/reward ratio of that investment? We must know what the possible returns are compared to the risk-free rate and whether the risk of the investment is justified for those returns?

The answer to this question can be different for different people. Let’s take a simple example. Assume that there is an investment opportunity where you must invest 1,00,000 for a period of five years. After five years, there is a 90% chance that you will earn 50,000 in profits. But, there is also a 10% chance that you will end up making a loss of 10,000. Would you consider this as a good investment?

Here’s how you should look at it. There is a 90% chance of making 50% gains and a 10% chance of making a 10% loss. If you did this same investment over and over again during your lifetime, you would end up making a profit of 44% (90% x 50% + 10% x (-10%)) on average. This implies a return of roughly 7.5% per year, which is almost identical to the risk-free return. In other words, this is an average investment.

In the above example, if the profit were 80% instead of 50% with everything else remaining the same, that would result in 11.3% returns and would be a good investment. Similarly, if the chance of making a 10% loss was 30% instead of 10%, that would imply 5.7% returns, making it a bad option compared to the 7-8% risk free rate.

There is no right or wrong answer to these questions. Depending on your personal situation, financial requirements and risk appetite, stock investments may or may not be suitable for you. If you are in your mid-thirties with stable income and limited financial liabilities, then a major portion of your savings should be invested in stocks. But if you are a retiree who solely depends on investment returns as a source of income, then stock investing is probably too risky for you.

What is the best way to invest in stocks?

Investing in stocks is by no means trivial. For starters, the different financial needs and risk appetite of investors means that the ideal investment is different for different people. Secondly, markets change continuously! Companies are constantly adapting to new environments, hurdles and opportunities. Small companies that adapt well can become tomorrow’s blue-chip stocks while mega brands can fizzle out if they fail to keep up with these changes. Companies like Nokia, Kodak, JP Associates, Tata Steel, and many others may have seemed like the perfect buy-and-hold candidates a few years ago but would have proved to be fatal investments in any portfolio. Picking stocks based on “trading calls” or “tips” is also a poor strategy for long term investing.

Instead, you need to understand the reason behind each investment. And you must build a well-diversified portfolio of stocks so that a few under-performers won’t hurt you too much in the long run. Finally, you must continuously monitor these investments to ensure that you don’t miss any new information.

What is the best time to invest?

"I can't recall ever once having seen the name of a market timer on Forbes' annual list of the richest people in the world. If it were truly possible to predict corrections, you'd think somebody would have made billions by doing it." - Peter Lynch

One of the biggest mistakes people make when they start is to confuse investing versus trading. The problem stems from the fact that 99% of the stock market advice available is misleading or outright inappropriate. Financial companies give “free” trading advice to investors because brokerage from frequent buying/selling is the primary source of revenue for them. Financial analysts constantly try to predict market movement in the short term in order to find trading opportunities in order to justify their existence. The bombardment of all this irrelevant information leads investors to start trading with their savings instead of investing for long-term.

Trading refers to the act of buying/selling a security to make quick profits by capturing short-term mispricing due to information asymmetry. In simple terms, if you have some material information about a stock that the market as a whole hasn’t accounted for, you can trade that stock and make quick money before the information becomes widely available.

Investing, on the other hand, is a whole different ballgame. By definition, stock investing implies putting your money in a business which will do well and generate higher profits as it grows over the course of multiple years. Contrary to trading, where timing is the only thing that matters, investing does not require you to achieve perfect timing. In fact, it is a well-documented fact that even “financial experts” can’t predict the best time to invest. The only way to improve your returns over long term is to invest consistently without worrying about the perfect time.