This misconception is because the average person views the stock market as a roulette table. Nothing is further from the truth. The stock market is extremely predictable. In fact with the right approach anyone can ensure returns that are higher than any other investment option such as bonds, real estate or gold.
This article is not a promotion for shares of any particular company, but will provide guidelines to help a prospective investor narrow down investment options.
To understand this little better lets look at the stock market in another light.
When starting a business there are two ways to raise capital –
- Loaned capital: This is borrowed money that is repaid with a fixed rate of interest within a stipulated time. The loan is returned immaterial of whether the business flourishes or not.
- Owned capital: This can be either the entrepreneur’s own money or money pooled in by family members, brothers, friends, etc. The share of each person in the company is in proportion to the investment contributed and therefore profits, after all expenses have been settled, are distributed proportionally.
Another option, which is a subset of owned capital, also available to an entrepreneur is to float shares of his company and raise his capital requirements from the public at large. This means that everyone who invests in shares has an ownership claim in the company to the extent of their investment.
Voila! Here we have the basic framework of the stock market!
To choose an investment strategy, the first factor to determine is the time frame of the investment. All equity investments should be ideally looked at with a time horizon of at least five years or more to reap optimum benefits. Is this a double or triple your money guarantee? Absolutely not! Now, since we understand the concept of a share, the returns to expect should always be in line with the growth potential of the company. A company cannot grow at 12% year after year for the share price to climb by 50%. Short term volatility in the stock market may see fluctuations to this degree, but over a period of time this volatility irons out to a flat rate of return that factors in profits and the growth potential of the company. Sentiment may run the market in the short term but long-term returns are always driven by fundamentals.
The time frame of the investment would also depend on the age bracket of the investor. A young executive starting his career can look at a higher exposure to shares whereas a senior citizen may not be comfortable with an irregular income and fluctuations that may erode the capital invested.
The next important factor in determining what kind of stock to invest in is to identify the objective of the investment. Is the investor looking at companies that pay high dividends or companies with a high growth potential? Companies that do not pay regular dividends are not always undesirable as these usually plow back profits into expansion plans and other growth potentials resulting in more aggressive returns than a high dividend yielding stock. This decision would depend on the investor’s appetite for risk as taking higher risks have the potential to earn higher returns.
The industry outlook for the medium to long term would also help determine whether to follow a growth strategy or a dividend yielding strategy.
Once this is identified, the next step is to decide what kind of company to invest in. Should it be small or large, an established one or a start up? Again, the thumb rule is higher risk leads to a potential for higher returns. Smaller companies are always more volatile and also have higher risks involved as they may not be able to tolerate high fluctuations during a downward market swing.
Finally, how does one time the market correctly? Fortunately there is no such thing as bad timing in the stock market. There is good timing, better timing and extremely lucky timing! Good time is investing at anytime without giving index levels and market sentiment a thought. If you put your money in during the Harshad Mehta peak or even the technology boom, you would have been handsomely rewarded for just sitting out the bad times.
On the other hand, with a little effort you can make an educated guess on whether you can get a better timing opportunity. This is called the PE ratio method of investing. PE is the price to earnings ratio of a stock. This is calculated on the present price of a share divided by the earnings forecasted for the company based on expected projects, work in progress and expansion plans. The lower the PE ratio, implying that the price is low for high earnings expected, the better the time to buy the stock. After viewing the average PE of the industry, the stock chosen should preferably be below or equal to the industry average. A higher than average PE indicates that the stock may be expensive.
Again, PE decisions cannot be made in isolation. Different industries have varying PE averages. The banking sector may have PE averages as low as 4X while IT can go up to 35X. This does not mean banking stocks will give better returns than IT. Trend forecasts and industry expectations should be the deciding factor here. PE ratio is only an indication of whether the stock price is too high to buy at present.
When investing savings with a business opportunity a few questions that come to mind immediately are
- Is it safe?
- Are the owners / initial contributors reliable?
- What is the nature of the business?
- How long have they been in this business and what is their area of expertise?
- What are the short, medium and long term plans of the company?
- How much return to expect?
- How long before it starts making profits / paying out returns?
- What is the industry outlook for the business?
These are the same questions to ask when finally choosing a stock.
In the past we have seen markets steadily rise over longer periods. Without active management we have seen the BSE Sensex climb from 100 in 1980 to 12000 in 2006. This means that if anyone had invested Rs. 100 in 1980, as on 1st June 2006, it is worth Rs. 10071 (which is considered a down market, if today is taken in isolation). This is approximately 20% compounded annually. The market peak during the technology boom was 6000; today’s down market still looks good in comparison.
Keeping these insights in mind, do not forget to invest some money today so that you can reap the benefits when we cross the 50000 mark on the BSE Sensex 20 years from now.
Courtesy:Chillibreeze
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