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Investing in stocks is NOT gambling
Rajesh Kumar, Outlook Money | June 23, 2008
The word stockmarket evokes varied thoughts - risky, gamble, complex, need a lot of money, only for 'finance' people, scam, and what have you.
Only a few will say it's a way to build wealth over time. In India, a little over 6 per cent of a household's savings finds its way to the capital markets; the majority goes into low-risk, low-return instruments like fixed deposits.
That stock investment is risky, is true. But it's also true that equity outperforms all the other asset classes in the long run. However, poor understanding and misinformation about the markets has kept most investors away from it. A better understanding of market functioning would break a number of these myths.
Just like gambling. A major reason as to why investors in India, and abroad, do not opt for equity as an asset class is that they believe the stockmarket is for gamblers.
That's not true. Gambling is zero sum game, that is, gain for one is loss for the other. In gambling the result is dependent on the outcome of throwing a dice; only one participant will win. In equity markets, if five investors hold the shares of the same company, and if prices go up, all of them will gain.
Buying an equity share means buying ownership in the company. Share prices will reflect the company's performance and shareholders have a claim on the net profits. This means that a company creates value for shareholders. In gambling, no value is created. It's the same money to be won or lost.
Of course, investors lose money in the markets too. Share prices change with expectations from the company. If a stock is trading at Rs 100 and the markets feel that its earnings will go down in the future, share prices will reflect this and go down. If an investor, unaware of this fact, buys that stock at Rs 100, there is a chance of his losing money.
Apart from the individual stock risk, an investor also takes market risk, which is not specific to the company, while buying equity shares. For instance, if interest rates move up, companies' interest liability will increase, which will negatively impact profits. Therefore, investing in the stockmarkets means picking fundamentally-strong stocks at the right prices.
Price is extremely crucial in stock investment. Stock X can be a good investment at 10 times earnings, which is a measure of the price paid for a share relative to the annual income or profit earned by the firm per share. This means that the same stock at 30 times earnings may be risky, as the investor is paying more for each unit of income.
Stock investment needs time, patience and fund management skills, all of which is not gambling. There is an element of risk involved, but this can be minimised. Gambling doesn't have such an option.
Gains go back eventually. Every market correction makes people think that no one can make money in the markets because even if it goes up, it eventually comes down.
Look at these figures. The bellwether, the Bombay Stock Exchange, sensitive index moved from the base of 100 in 1979 to 20,000 in 2008 before correcting and reaching its current level. Simple calculation tells us that Rs 1,000 invested in 1979 will be worth Rs 160,000 today, which means a compounded annual growth of 19 per cent. If we look at individual stocks, Bharti Airtel [Get Quote] has moved from Rs 40 in June 2003 to Rs 820 in June 2008, a gain of over 1,900 per cent. Similarly, Reliance Industries [Get Quote] has moved up 1,000 per cent in the same period.
Gains can be lost for some time as price movements are never unidirectional. But, if you have picked up the shares of a company with sound fundamentals at the right price, there is very little chance that you will lose money in the long run. However, if you buy into a weak company or even a strong company at a high price, the gains will be restricted and chances of losing money will also be high.
It's an exclusive club. Many believe that the stockmarket is an exclusive club of brokers and big investors and that one needs a lot of money to profit from investments in it. The stockmarket was out of the reach of lay investors till some time ago. But technology has changed the rules of the game. Now, with a demat account, investors can buy just one share. The cost of transaction has come down significantly from 5 per cent of the value to 0.5 per cent. The availability of information has also increased. corporatisation of brokerage firms has increased the coverage of research, which is now shared with investors. Moreover, there are professionals now who advise investors on buying and selling stocks.
You need to take extra risk to make money. No risk, no gain. But high risk does not necessarily translate into high gains. When the markets fell in January this year, retail investors suffered the most.
Investors with leveraged positions were forced to sell. Taking a leveraged position means buying stocks with borrowed money. If an investor has Rs 100 of his own in the markets and takes Rs 500 from the broker to invest, his total position will be Rs 600.
Now, if the markets fall by 10 per cent, the value of his total investment will be reduced to Rs 540. Since he has to return Rs 500 to his broker, he will be left with Rs 40. A loss of 60 per cent on his investment.
At times, several investors choose to expose themselves to very high risk. Investors should not leverage in equity markets or get carried away with a particular sector or stock.
The portfolio should be well-diversified and have a mix of sectors. Stocks from the FMCG and pharma sectors provide a cushion during downturns because of their defensive nature and earnings visibility.
Quick returns. Investors entering the equity markets with a very short-term horizon to make quick money are exposed to very high risk, as the markets are volatile in the short run and can move either way. These investors generally invest when the bull market is peaking. A rising market attracts money which would not have come to it otherwise.
Confidence among investors goes up and they start believing that the markets cannot fall. Rising confidence starts bringing short-term money into the markets as investors suffer from the illusion of control. And when the cycle reverses, investors with the short-term horizon and money suffer the most.
Stockmarkets are not the place to make quick money. Ideally, you should invest money that you would not need in the next three years in the markets.