Investors, take note! - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

Investors, take note!

Mar 28, 2005

The world of stocks is a highly dynamic one. One has to be constantly on one's toes in order to keep abreast with the latest developments taking place. To a layperson, it can be intimidating, with stock prices constantly changing every second. Of course, we have seen during the (in)famous market crashes that can happen when things do not go according to what the market expects. An example is May 17, 2004, when the NDA government lost power at the Centre. The market had expected the NDA to retain power, and when that did not happen, it tanked by a massive 565 points, falling in intra-day trade by over 800 points! When this kind of activity makes even the most experienced among us quiver, imagine what the common investor must be thinking! In this article, we attempt to simplify matters for the common investor, by explaining some important terms that every investor must be aware of, not just while investing in shares, but for any other investment.

Concepts of 'Risk' and 'Return'

Risk, in simple terms, can be defined as the possibility of the stock showing negative returns on an investment. While quantifying and calculating risk, we generally use a variable called as 'beta'. This implies the volatility of the stock with reference to the benchmark index, generally taken as the BSE-Sensex or the NSE-Nifty. If the beta of the stock is 1, it means that the returns in the stock are highly correlated to the benchmark index. Stocks in sectors that closely track economic growth like cement, infrastructure or oil and gas generally show this kind of beta. If the beta is higher than one, it means that the stock is more volatile than the index, and in a bull market, will generally outperform the index. However, in times of a downturn, the fall in such a stock is generally more pronounced than that in the index. Examples are stocks in high-growth sectors like software, BPO, and pharma. If the beta of a stock is less than one, it means that the stock is less volatile than the index, and the company operates in a sector that is relatively stable, without much volatility. An example of such a sector is FMCG.

ER = RFR + 'beta' of the stock (MR - RFR), whereER = Expected returns,RFR = Risk-free rate (generally taken as the yield on 10 year G-Secs), andMR = Market rate of return

Returns are correlated with risk. The lower the risk, lower the returns that can be expected. On the other hand, the higher the risk associated with the stock, the higher are the returns that can be generated, in order to compensate the investor for bearing such a high risk. Software companies have a higher risk profile, thus, the returns they have generated over the years have been higher, as compared to low risk sectors such as FMCG. Of course, investors need to note that this is a generalization, and the specific performance of a company in its sector of operations may vary depending upon the performance of that company, the market perception, ability to survive in a downturn, future growth prospects, ability to corner that growth, and other such factors.

Investment horizon

Any investor, before making an investment decision, must be clear about the kind of time he/she is willing to give his/her money to grow. The equity markets are home to all kinds of players - short term 'punters', who invest based on technical analyses/tips, also known as 'speculators', arbitrageurs, who take advantage of the price differentials in different markets, and the long-term investors, who generally view the market over a long period of time, based on fundamentals.

Considering the high-risk nature of the equity markets, for retail investors, it is advisable to invest with a long-term horizon in mind. Equities as an asset class have outperformed other asset classes over a longer period of time. They are the best possible hedge against inflation and in times of high inflation, are possibly the only assets that will give you a positive real rate of return after taking inflation into account.

Therefore, any investor must have a clear idea in his/her mind as to the time frame of the investment. Long term investing, taking into account fundamental growth stories, and strong future growth prospects have the potential to deliver solid returns on investment. This is the best way to reduce risk. As the legendary investor Warren Buffet has said, "Risk is not knowing what you are doing." Studying the company/sector thoroughly before taking any decision is essential. In case any investor does not want to enter the markets directly, he/she can always take the mutual fund route, and leave his/her money in the hands of experienced fund managers with good track records.

Asset allocation

In simple terms, this means spreading your investments across various instruments and asset classes, like equities, debt, bank deposits, mutual funds, post office savings, property, commodities, art and so on. This is a vital term that needs understanding. It is always a wise decision to diversify your investments across various asset classes, so as to reduce the risk of a particular asset class giving low or negative returns. Putting all your eggs in one basket is a risky strategy. A good mix of equity, debt, mutual funds and other asset classes provides safety as well as the possibility of generating high returns. In fact, even in each asset class, like equities for example, it is advisable to diversify and have a number of shares in different sectors in one's portfolio, so as to reduce dependence on just one stock or sector. Similarly, for mutual funds (MFs), it is better to invest in schemes with a good track record, and from a variety of fund houses.

As far as the exact allocation to each asset class is concerned, it depends on person to person, the risk profile of the investor, and the time horizon of the investment. Generally, younger investors who have started out early in their careers can afford to take higher risk and go for a greater proportion of equities and equity mutual funds in their portfolio, while those who are about to retire and thus, will not have any direct source of income, are better advised to have a high proportion of investments in safe instruments such as bank deposits, post office savings, and pension plans.

Conclusion

We have understood the basic terms that any investor needs to get clear in his/her mind before taking an investment decision. Depending on the age, risk taking ability and time horizon, an investor should accordingly put his/her money in different asset classes in the proportion that suits their unique needs and requirements the best. Investing on the basis of rumours or speculation is a high-risk activity, and must be avoided as far as possible. With the complexity and dynamism of the financial markets increasing with the passage of time, there is a massive information overload for all investors. Big investors like Foreign Institutional Investors (FIIs) have the time and expertise to manage such risks. But for a retail investor, this can be highly intimidating. It is best to ascertain one's own unique requirements based on the parameters discussed above, depending on which one can draw out an investment plan.

Discipline is the key to good investing. One must have patience, and give his/her money the time to grow. In the long term, this is a factor that often differentiates the winners from the losers in the game. Investors must inculcate the habit of disciplined investing in them and over a period of time, this will be hugely beneficial in enabling them to earn handsome returns on a diversified investment portfolio, with minimal risk. Investors, please take note!


Equitymaster requests your view! Post a comment on "Investors, take note!". Click here!

  

More Views on News

Better Days Ahead for the Markets (Fast Profits Daily)

Oct 22, 2020

Commodity prices are signalling an economic recovery.

Will Blackstone Group Manage L&T Mutual Fund's Assets Successfully? (Outside View)

Oct 22, 2020

PersonalFN explains whether Blackstone will be able to successfully manage L&T mutual fund's assets in the event of a potential acquisition.

Your "I Was There" Moment in History Could Be Today...Don't Miss It (Profit Hunter)

Oct 22, 2020

The last time such a moment showed up in history, few investors grabbed a 65 bagger.

An Update for Those Looking to Trade Crude Oil and Natural Gas (Fast Profits Daily)

Oct 21, 2020

Trading crude oil and natural gas in the near future will be challenging. Here's why...

Will Pharma and Healthcare Funds Improve the Health of Your Portfolio? (Outside View)

Oct 21, 2020

The COVID-19 pandemic has turned to be a high-growth opportunity for India's Pharma and Healthcare Sector.

More Views on News

Most Popular

My Latest Stock Recommendation (Fast Profits Daily)

Oct 9, 2020

How I picked an exciting stock using trends from both the commodity and equity markets.

The 'Seedhi Baat, No Bakwaas' View on ITC (Profit Hunter)

Oct 12, 2020

Is ITC an investment or a speculation at current levels?

One of the Best Investment Opportunities in the Market Right Now (Fast Profits Daily)

Oct 16, 2020

The one sector that you should be looking at to make good profits.

The Inflection Point for Defence Stocks is Getting Closer (Profit Hunter)

Oct 9, 2020

Few Indian defence companies could use their engineering capabilities to eventually become global leaders.

More

Covid-19 Proof
Multibagger Stocks

Covid19 Proof Multibaggers
Get this special report, authored by Equitymaster's top analysts now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Oct 22, 2020 (Close)

MARKET STATS