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| Equtiy Basics |
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What is Share/ Stock/ Equity?
A share is one of a finite number of equal portions in the
capital of a company, mutual fund or limited partnership, entitling the owner
to a proportion of distributed, non-reinvested profits known as dividends and
to a portion of the value of the company in case of liquidation. Dividends are
not guaranteed. They may be increased if the company performs well, but they
may also be reduced or eliminated if the company performs poorly.
So when you purchase shares, you become part owner of a
company. As an owner, you are usually entitled to voting rights on the board of
directors and corporate policy.
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Why Invest in Stocks?
Although past performance cannot guarantee future market
results, Stocks, historically have outperformed all other long-term financial
assets. They are the only financial asset that has significantly outpaced
inflation over time.
Investors buy stock to potentially increase their return on
investment in one or both of two ways:
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Dividend Payments
- Many companies pay portions of their annual profits to stockholders in the
form of dividends. Stocks with consistent track record of paying attractive
dividends are known as income stocks because investors often buy these stocks
to receive the income by way of dividends in addition to being invested in the
company's future growth prospects.
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By Selling the stock for more than they originally paid - Some companies
reinvest most of their profits back into the business in order to expand.
Stocks of companies with sales and earnings that are expanding faster than the
general economy and faster than the average company are called growth stocks
because investors expect the company to grow and expect the stock price to grow
with it. When such increase in the stock price is witnessed, investors can sell
their shares for an amount greater than their purchase price, thus pocketing
the difference as profit.
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Modes of Stock Purchase
Stocks can be purchased individually (meaning you purchase
shares of stock in one particular company) or as part of a pool investments,
such as mutual funds.
Mutual funds are baskets of stocks that are available for
the fraction of the price you would need to buy the same stocks individually.
That's because a large number of investors pool their money together and invest
in the entire portfolio of stocks.
Professional money managers direct the investments within
mutual funds, choosing each of the individual investments based on the mutual
fund's investment goals. For example, some equity mutual funds invest in
well-established companies that pay regular dividends. Others invest in
younger, more growth-oriented firms or companies that have been operating below
expectations for several years.
Note: As with the purchase of individual stocks, your
investment return and principal value of an investment in mutual funds will
fluctuate. Your shares may be worth more or less than your original investment
when redeemed.
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What are the different kinds of risks one should consider
while investing?
Risk in investments can be of the following types:
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Market Risk or Volatility:
This refers to the fluctuation in the value of investments due to changes in
the price of the stocks included in an investor’s portfolio which could be
caused by a variety of factors such as performance of the company, policy
announcements, political factors etc. Even a portfolio of well-diversified
assets cannot escape all risk.
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Inflationary risk:
Also known as purchasing power risk, this is the decline in the purchasing
power of money over time, so that even the "safest" investments can leave
investors with substantially less purchasing power. For example, assuming an
inflation rate of 4% for the next 10 years, if you have Rs.100 today, 10 years
from now inflation will have eroded that Rs.100 so that it is worth only Rs.68.
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Investment or credit risk: This is the possibility that a company in
which an investor is invested in may not be sufficiently profitable to remain
in business.
Another manner of classifying risk in securities is as
follows:
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Unsystematic Risk:
Unsystematic risk affects a very specific group of securities or an individual
security. Internal risks such as strikes, management policies, etc. are to a
large extent controllable and are examples of non-systematic risks. An investor
can easily manage such non-systematic risks by having a well-diversified
portfolio spread across the companies, industries and groups so that a loss in
one may easily be compensated with a gain in other.
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Systematic Risk: The risk inherent to the entire market or entire market
segment is called Systematic Risk. It is also known as "un-diversifiable risk".
Such risks are external and beyond the control of the company. Examples of such
risks are economic, political and sociological changes. Their impact is on
prices of all individual stocks and they move together in the same manner.
Therefore quite often the stock prices may be falling despite good company
performance and vice versa.
Since higher returns are associated with higher risks, you,
as an investor, need to understand your risk tolerance level and certain
principles of investing which can help you diversify and mitigate this risk.
Before venturing into the world of stock investments, consider:
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Are you conservative, aggressive or speculative in your approach to investing?
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Are you comfortable owning aggressive stocks?
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Are you looking for a steady stream of income, long-term returns from growth or
very high returns from risky short-term trading?
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Factors affecting Investment Decisions
Before you begin investing, it's helpful to understand some
of the factors that will affect your investment decisions, such as:
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Risk
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Liquidity
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Time Horizon
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Total Return
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Diversification
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Tax Consequences
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Rupee Cost Averaging
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Risk:
Risk in investments can take various forms. For details click here.
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Liquidity:
A "liquid" investment is one that can be readily turned into cash if you need
the funds on short notice. Investments can vary greatly in their degree of
liquidity. Shares can be traded on any business day at their current market
value, which may be more than, equal to or less than the amount initially
invested.
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Time Horizon:Different investors have different time frames in which
to achieve their investment objectives. Generally, young investors with long
time horizons should be able to assume greater risks because they have more
time to offset any losses with the higher return potential of investments with
greater risk. Older investors, however, often choose to reduce risk because
they have less time to recoup losses.
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Total Return:
All investments provide one or a combination of two different types of returns
to investors - income or growth. Income is the dividend earned from stocks.
Growth is the price appreciation of the security. The total return of an
investment is the combination of income and growth realized over a given time
period. In selecting investments based upon their expected total return, you
should understand which portion is generated from income and which from growth.
Usually, the greater the reliance on income, the lower the market risk but the
greater the long-term purchasing power (or inflationary) risk.
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Diversification: Building a diversified portfolio with securities spread
across different investment classes can help you avoid the risk of having all
of your eggs in one basket. By mixing industries and types of assets, you
spread your risk. A particular market condition may have less impact if your
portfolio consists of a wide assortment of securities than if you purchase only
one type of security.
Most beginning investors don't have sufficient capital to properly diversify
their portfolio by purchasing individual securities. Investing in mutual funds
allows you to buy a professionally managed, diversified portfolio with
relatively small rupee amounts. In addition, many mutual funds allow you to
take advantage of rupee cost averaging by investing at regular intervals.
Note: Mutual fund investing involves risk. Your principal and
investment return in a mutual fund will fluctuate in value. Your investment,
when redeemed, may be worth more or less than the original cost.
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Tax Consequences: Not all investment returns are subject to the same taxation.
Short term and long term returns are taxed at different capital gains rates or
even taxed as business income. The taxation policy should be kept in mind while
deciding which investments to make.
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Rupee Cost Averaging: Rupee cost averaging, the practice of committing a fixed
amount of money to an investment program on a regular basis, is a popular
practice with many long-term investors. By investing a set amount regularly
(usually monthly or quarterly), investors are able to avoid the pitfalls of
trying to time market peaks and valleys. Also, because the amount of the
investments is set, investors who practice rupee cost averaging buy more shares
of a stock or mutual fund when they are less costly and fewer shares when they
are more expensive.
Like any investment strategy, rupee cost averaging doesn't guarantee a profit
or protect against loss in a declining market. Because rupee cost averaging
requires continuous investment regardless of fluctuating prices, you should
consider your financial and emotional ability to continue the program through
both rising and declining markets.
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