STOCK MARKETS – A DANGEROUS TERRAIN OF GREED AND FEAR

Every soul in the world would like to be rich. There are a number of avenues through which you can make money from money. Whether it be pumping you’re earning in bonds, fixed deposits or for that matter into buying gold/commodities; people try out ways in which they can make money, yet face the minimal level of risk. Options galore further into buying land or property or investing in a business idea. But one way of investing has been around for ages, investing in the stock market. Be it USA, Europe or Asia, millions of businessmen and salaried employees look to make money by buying stocks of businesses. In this article I will throw light on major aspects on investing in stock market.

EMERGENCE AND RELEVANCE –

The onset of stock trading could be traced back to 1460 in Antwerp, Holland. Formally speaking, the Amsterdam stock exchange is regarded the oldest one which began trading in stocks and bonds by 1602.1 But then what are stocks? Stocks or shares are primarily speaking a way by a company becomes public and through these stocks common people can buy a portion or majority stake of the company depending on the number of shares he owns. This is a quick and popular way by which company can raise money in order to either expand operations or acquire competitors. Whether a firm needs capital for growth or to repay debt, it can always offer a part of its stake to the public in order to get money for the work.

MAJOR MARKETS - 

Some of the major stock markets are the Dow Jones Index and NASDAQ of USA, FTSE (Financial Times, Stock Exchange) of England, Heng Seng of Hong Kong, NIKKEI in Japan as well as CAC and DAX in France and Germany respectively. Some of the major emerging market indices are from India (BSE Sensex), China (Shanghai Composite) or Russia.

MECHANISM –

Trading or investing in stock markets requires more than pure knowledge of finance.  The mechanics of trading daily or on a short term basis is totally different from buying shares for three to five years. Here is where a lot of research about the company, its management, products and its demand, is required before you push that buy button. While in trading a trader needs to analyses trends, charts as well as market mood in order to make money daily or on a weekly basis.

TRADING IN STOCKS –

When it comes to trading in stocks, there are a number of instruments that traders can use to make money. One way is to buy shares outright in cash, which is known as delivery buying. Normally a trader buys on delivery to take multi day position in the stock in order to take advantage of the positive trend persisting in the stock. A trader rides the trend for as long as it do not turn and makes money by trying to buy low and sell at the highest level. Another way to trade is through options and futures. A future contract is a legally binding agreement to sell or buy any underlying stock at a predefined future date.  In this case, there is no delivery buying of stock but a contract is bought and sold taking into consideration a future price and date. Traders deposit an initial amount to the future exchange known as margin. Each day this amount is adjusted on the bases of the futures price of the said stock. When the contract closes, the initial margin is credited back to the beneficiary account along with any gains or losses.

INVESTING IN STOCKS –

When it comes to investing in stock markets the scenario changes completely. A stock investor would try to gauge the value of a company based on a number of factors. These factors are totally different from the ones mentioned above. An ardent investor closely looks at the financial statements of the firm along with the quality of management, growth of the business, longevity of the business as well as the price that business is quoting at the stock exchange. Such thorough analysis requires an individual to have an analyst’s mindset. He would need to have patience to buy the best businesses around and stick with it through thick and thins. Businesses that have strong balance sheets, low to no debt, high profitability, decent return ratios as well as good cash on books, would tend to do well over a long period of time.
On the contrary, businesses that are more capital incentive, require constant money infusion and have high debt on books, tend to perform by and large ordinarily over the long term. These businesses depend on growth cycles to turn their fortunes around.

COMPARISON WITH OTHER ASSETS –

When it comes to making money through investments in stock market (most people invest over a number of years rather than trade daily), the massive question is, am I investing in the right asset class? The data on return of investment in different asset classes in India reveals a lot. If we take the return on BSE SENSEX (INDIA) return, and compare it to return on investment in Gold and Bank deposits, we get the following numbers. Hundred Thousand Rupees invested in 1980 in the India stock market would give you a post-tax return of 18.65% annually over 34 years.(period analyzed is between 1980-2013) In the same period, Gold had a post-tax return of 11.2%4 whereas the same amount invested in a bank deposit for 34 years would yield an annualized return of 7-9% pretax.3 Similarly in the United States the Dow Jones has given a return of more than 6% CAGR over the last thirty years where as the bank deposit rates has remained subdued between 0-2%.5 Similarly, return on gold in the US has been very subdued. Over the last ten years the annual CAGR return on gold has been a mere 4.5%.

As it is evident from the above discussion, a trader may win or lose on the stock exchanges worldwide, but an investor would do very well if he invests wisely in a set of stocks and keep adding to the investments over a long period of time. Also what can be ascertained is that, all be it the exchange rate parity exists between India and USA, yet many foreign institutional investors from America find India as an attractive market as it gives them an opportunity to earn a return three times as better than the US market would.


RISK ASSOCIATED WITH INVESTING IN STOCKS –

Although stock market is regarded as the best asset class over long term, it has a fair amount of risk attached to it.

PRICES ARE IRRATIONAL –

The basic premises of trading or investing in stocks is to ascertain the fair value of a business and correspondingly the optimum stock price. This is because stock markets worldwide are irrational and prices keep changing every second. Hence if someone believes stock A should quote at $20 after calculating various parameters, the stock will, almost certainly be trading below (cheaper) or above (expansive) this price. The risk is that sometimes sentiments may take the price of your stock crashing down even if its fundamentals suggest otherwise.

CORPORATE GOVERNANCE ISSUES –

A major risk factor is the management quality. A common investor may find it extremely difficult to accurately gauge the intentions and quality of the top management. We have seen issues relating to insider trading, pledging of shares as well as auditors resigning ahead of earnings. Once this sore side of a coveted firm crop up, there could be panic selling in the stock and the common investor is left in the lurch. It takes years for such companies to reclaim the trust and goodwill that it has lost.

GOVERNMENT AND LEGAL INTERFEERENCE –

Apart from internal wrangling in a company, any company is bound to rules and government notifications. If the company ends up losing a major legal battle with a competitor that could hurt its profits appreciably, may end up ruining once portfolio. Similarly a court order banning use of a particular product, for instance banning of PLASTIC in many states of India, or use of old cars on roads, may end up denting the whole business of a company. An investor has to be on his toes to recognize such dangers and invest wisely.

OTHER EXTERNAL FACTORS

More than company numbers and management skills, traders and investors are more wary of many external factors. For instance the 9/11 attaches of 2001 stalled US markets for a week and when trading started on Sep 17th, the markets fell over 7% in a day. That was at that time the biggest intraday fall in US history.

Other issues that could affect the markets could be federal election results, assassinations, major calamities such as the Tsunami that took place in japan in 2011. The NIKKEI fell over 6 % immediately after that. Hence the risks do complement the returns an investor gets through equity investment.