Equity Basics | Functioning of stock market | Starting to trade
Wouldn't you love to be the owner of a prosperous business without actually working for the company? Imagine having the ownership in companies, seeing those companies grow, and collecting the dividend cheques year after year, without involving yourself in the workings of the business. This situation might sound like a fancy dream, but it's closer to reality than you might think.
Materializing this flight of imagination could be possible only by holding one of the greatest tools ever invented for building wealth, undoubtedly, the stocks or equities!!!
A share of stock (also referred to as equity shares) represents a share of ownership in a company. For growth of the business, a company can raise money from the public by offering them ownership in return for their money. Once the money is raised, the company lists on the stock exchange where the shares of the company can be openly bought and/or sold by the investors. So basically if you want to invest in a company, you will have to buy the shares of that particular company from the stock exchange at the current share price, provided that company is listed on the stock exchange.
Equities are a part, if not the cornerstone, of nearly every investment portfolio. When you start on your road to financial freedom, you need to have a solid understanding of equities and how they trade on the stock market.
Now you might be thinking--
1. Returns: Stocks can help you build long-term growth into your overall financial plan. Over the longer term, shares can produce significant capital gains through increases in share prices. Some companies also issue free or bonus shares to their shareholders as another way of passing on company profits or increases in their net worth. History has repeatedly demonstrated that stocks, as an asset class, have outperformed every other type of investment over long periods of time. The graph below shows how have different asset classes fared between 1980-2006:
CUMULATIVE ANNUALISED RETURNS (1980-2006)
Over the last few years, even the average person’s interest in the stock market has grown exponentially. What was once a toy of rich has now turned into a vehicle of choice for growing wealth. This voluminous demand coupled with the development of India as an emerging market in the world scenario, integration of Indian capital market with several other markets of the world and striking advancement in our trading technologies has opened up our markets to a large investor base ranging from multi-million dollar FII’s to every second household in our country.
2. Ownership: Holding shares of any company entitles you to become one of the several owners who are called the shareholders of the company and also empowers you to have a claim on virtually everything the company owns. In reality, this could mean that you own every piece of machinery, furniture, premises, contracts or trademarks that belongs to the company. Now, isn’t that such a great idea?
3. Limited Liability: Another very attractive part of owning shares in any company is the limited liability feature attached to it, which means that as one of the many owners, you are not personally liable in case the company becomes incapable of meeting its debts. Wow!! That means that even while you gain the benefits, you are not supposed to be sharing the losses. In the worst case, the maximum you can lose by holding shares is the value of your investment. Isn’t it then really worth a try?
4. Tax Benefits: Not only the companies themselves but even the government promotes investment in the equity market. And that is how investment in equities reaps great tax benefits. The dividend income generated from shares of a company is completely tax-free in the hands of shareholders like you and me!!! For those matter even long-term capital gains the government does not tax arising on equity investment at all. That would mean that if you invest in a company and keep the shares for 12 months, you don’t need to pay any tax on the income that you earn on selling those shares after 12 months. That surely is heavens in a country like ours where virtually everything is under the tax bracket. Besides, short term capital gains tax on shares is also just a mere 10% as compared to investment in other asset classes that attract short term capital gains tax of 30%*.
5. Flexibility and Liquidity: You can choose to buy or sell shares of any company whenever you want and from wherever you want. Now that really sounds like some hell lot of flexibility!!! In other investments, like real estate, you cannot liquidate your investments easily even if you wish to. They often take longer time frame to sell and your money thus gets blocked. Whereas in shares your investment becomes highly liquid. If you want to liquidate your money, all you have to do is – click a button, enter into a trade and you’ll be able to fetch your money back on the very 2nd day (T+2 settlement regime).
*Tax rate subject to Income Tax Amendment
Shares are exciting!
Apart from the very real financial benefits of investing in shares, shares also appeal because individuals like to pit their wits against the market. They derive tremendous satisfaction from picking a winner and letting their friends know all about it.
There is a burgeoning investment community out there. Today, the equity investor has a vast range of information sources and electronic tools and services from which to choose. The growing interest in investment is reflected in vastly increased media coverage, on TV, radio, newspapers and the Internet. The Internet in particular has made up-to-the-minute news and information easy to access by investors and much of it is free.
Whatever said and done, equity is a must for any well-balanced portfolio. So, irrespective of whether you are a high net worth investor or a small retail investor and irrespective of whether you have a large or timid appetite for risk, you must hold some portion of your assets in equity. This is because it is the only instrument that has the ability to truly deliver a high return, when held over a long period of time.
However, the amount of equity that you hold in your portfolio is a very subjective decision and will depend upon various factors. These include your investment objectives, time horizon and risk appetite. But as a general guideline, there’s a Rule of thumb which states that to decide upon the proportion of your assets that should go into equities, reduce your age from 100 and that proportion of your money which should be put in equities. Say at the age of 60, you should invest an amount equal to 40 per cent of your total investment and at the age of 70, an amount equal to 30 per cent. The remaining can be invested in fixed income securities.
Now considering the vast benefits of owning equities and seeing the attractive returns that they fetch in hand, I am sure you might be getting the butterflies in your stomach. Several questions might be burgeoning in your mind. How to start about investing in the financial markets? Whom to go to? How to keep yourself updated? How do you meet other people who are involved in buying and selling shares? But, hold on at this moment just go and sip a cup of coffee and keep aside all your questions. We are here to solve all your problems and give answers to all your queries. Just go through our knowledge centre to find answers to some of the most basic questions. And for the rest, our team at Arihant would enlighten you at every step as you associate with us.
Whether you want to invest independently, you need advice or you want someone else to invest for you, there are different avenues to get started to investing in the stock market. You have the choice to invest on your own (direct investment) or use professionals and experts to invest money on your behalf in return for a fee (indirect investment) through portfolio management services (PMS) or mutual funds.
A. DIRECT INVESTMENT
You can directly invest in the shares of a company through Primary Markets or Secondary Market. Shares generally have two stages in their lifespan – Initial Public Offering (Primary Market) and Listing (Secondary Market).
1. Primary Market
The first stage is when the company initially issues securities to the public to raise money for the business. This is called Initial Public Offering (IPO). Investors or dealers generally buy the shares in the primary market and resell them in the secondary market.
Arihant provides complete transaction and research support to investors for investments in IPOs.
E-IPO’S: Now-days companies enter into agreements with stock exchanges to offer shares to public through the online mechanism. The brokers registered with SEBI (like Arihant) accept orders from the investors and place them with the company. Registrar is appointed by the issuing company that has electronic connectivity with the exchange. With a broker as an intermediary, investors are completely freed from the tedious process of filling in long applications and standing in queues to submit them that had to be encountered earlier.
With Arihant online IPO service (i-Trade), you can invest in IPO just by giving in the name of the company and the quantity of shares you want to invest in, and the rest of the paperwork would be managed by us .
2. Secondary Market
The second stage is when the shares of the company are listed on the stock exchange (NSE and/or BSE) after the shares are issued to the public. Once listed, the shares are available for trading for the investors. Like any other marketplace, there are buyers and sellers of shares in the market. Existing shareholders sell their shares to the buyers at an agreeable price, but there is no interaction between them, as the orders are placed online and is settled by the stock exchange. The buying and selling of shares is done through a stock broker like Arihant.
National Stock Exchange (NSE) and The Stock Exchange, Mumbai (BSE) are the two leading stock exchanges of India where most of the transactions take place. Working of stock exchanges has been further explained in details in the later section.
B. INDIRECT INVESTMENT
1. Investing through Mutual Funds
Investing in shares directly in the stock markets is certainly exciting but it may not be for everybody.
There are many who will wish to gain exposure to equity markets but who will feel they do not have the time, inclination or expertise to devote themselves to the task of choosing individual shares and monitoring their portfolio.
For those people, investing in an equity fund is the answer. Simply put, mutual fund works on the concept of pooling in money. Investors give their money to the experts and the experts invest on their behalf. These funds are split into 'units' and an investor can purchase as many units at the current Net Asset Value (NAV) as he or she requires. If there is profit in investment, they all benefit and if there is any loss, they suffer. Experts get certain fee for investing on their behalf. Investing in a mutual fund is slightly expensive than 'direct' form of investing. However, the decision-making and procedure of investing is transferred to the mutual fund company.
But remember, mutual funds do not work on charity. They charge a fee to the investors for their service.
Mutual funds are designed to offer the individual investor diversification and professional money management, even with low investment amounts. For naïve investors, it is a common practice to invest in the mutual funds.
You can choose a fund depending on your particular investment preferences, for example risk level, industry sector, international stocks and so on. Funds also offer the opportunity to diversify investments without the need to invest in lots of different companies to spread your risk.
You can either buy funds direct from the mutual fund company, or through a stock broker, who give you access to a wide range of funds, and also guide you which fund is the best for you.
More on Mutual Funds
2. Investing through Portfolio Management Services
You want to make investment in the stock market, but you do not have the time or may not understand the stock market mechanics. That is where Portfolio Management Services (PMS) will help you.
PMS is a unique solution for those who are looking forward to tap the growth opportunities in the financial markets but do not have the time and specialized skills required for the same. PMS allows you to delegate the responsibility of managing your investments to a team of investment experts who understand your investment goals and work towards achieving them. They will take complete responsibility for managing your investments and take investment decisions in your best interests.
Minimum requirement: You need to have atleast a minimum of Rs 5 lac to invest with a PMS, however some companies have a higher minimum requirement as well.
Charges: Different companies have different way of charging for their portfolio management service. Generally, apart from the taxes, companies charge a fixed fee and performance fee.
Click here to know about Arihant PMS
So you might be wondering, which investment avenue is best for me to invest in the stock market?
Well, let’s put it this way. While choosing any investment vehicle, you have to keep in mind your skills, time available with you to create and maintain your investments and of course and the costs involved.
If you have the skills and time available with you then ‘direct’ form of investing is ideal as it has the least of costs amongst all other vehicles. For investors -- who do not have the skills or the time -- mutual funds seem to be the best option. They offer the benefit of your money being managed by the expert fund managers.
PMS works better if you can make minimum investment of up to Rs. 5 lakhs. It offers you more flexibility as compared to mutual funds; here you can interact with your portfolio manager on a regular basis and it also entails lower costs compared to MFs.
There are various risks that companies are exposed to and when you invest in equity, your returns are affected by these risks. These are:
- Interest Rate Risk: Change in interest rate directly affects the security prices of the company. An increase in interest rate would lead to fall in share prices and vice-versa.
- Inflation Risk: It arises when the cost of living index is higher than the rate earned on investment as a result of which the entire earnings are eroded by the increased inflation.
- Business Risk: i.e. the risks associated with the prosperity of a business that affects its earnings. Change in supply of raw materials, market demand for a product may have a direct bearing on the earnings of the company.
- Financial Risk: The skill with which a company can maintain optimum capital structure with right mix of debt and equity affects its growth prospects.
- Industry Risk: The changes in technology, regulations, fashions, etc. will affect the performance of an industry and hence the company directly.
- Market Risk: Change in stock prices due to change in investor’s attitudes and preferences, political and economic instability, exchange rate fluctuations are covered in market risk.
Most risks associated with investments in shares can be reduced by using the tool of diversification. You must have heard of the old adage of ‘not putting all eggs in one basket’. This is what exactly diversification does. Your equity portfolio should not be concentrated to one particular investment style or a particular sector. The portfolio pyramid below is a way of looking at your equity portfolio to determine if it is well-diversified. As you can see below, the pyramid breaks down into manageable layers, making it easy to uncover any unhealthy symptoms:
To reduce the risk,
- make sure that your portfolio consists of shares across various sectors like automotive, engineering, financial services, IT.
- the companies are all located in different regions.
- the companies you have invested in belong to large-cap, mid-cap and small-cap clan.
For more details on diversification click here
Your investment and your personal and economic circumstances will ultimately determine your attitude to risk and investment strategy. Before you invest in equities:
Assess your personal circumstances: Before you embark on equity investment, it is important that you assess your current personal and financial circumstances and your investment goals. Start with understanding your attitude to risk. If you want to make gains in the stock market, you may have to take some risks. Your age will also be a factor. Younger investors can perhaps afford to be more aggressive and take higher risks as they have a longer remaining working life to make up for setbacks.
Obviously, whether you have dependants or not will affect your investment decision. You might personally have a strong risk tolerance but this may be tempered by the knowledge that your loved ones' future may be tied up with your investment decisions.
Assess your financial position: You will need to relate your financial position to your overall financial goals. You will also need to place a time horizon on those goals. For example, you may need to ask yourself whether it might be better to pay off personal debt rather than effectively funding your stock market investments through expensive borrowings. It is advisable to invest with money you have rather than money you owe.
Asses your financial objectives and your time horizon: See the following three investor profile to understand if share investment is right for you:
||Swapnil and Shikha Dua
||37 and 35
||Self-employed, run their saree boutique
||Married but no dependants
||Married with 2 children 11-13 years
||Monthly pension and rent income provides him and his wife the lifestyle they desire. They have no financial commitments. Sunil has a lump-sum amount that he receives from pension scheme in a savings account has no existing shares in his portfolio. But has a keen interest in business and follows markets regularly in paper.
||His income is sufficient to meet his requirements and manages to save little every month. Has investment a small amount in liquid funds but is not happy with the returns. Has no investments in equities, but is aware of the benefits of investing in equities.
||They have a moderate income that provides them with a comfortable lifestyle. They don’t get much time from their own business and can’t provide time for researching investment opportunities.
||To gift his granddaughter a lump-sum cash investment on her 18th birthday in 10 years time.
||He needs to buy a house of his own in two years and needs to build on his existing savings so can provide for the deposit for the house by that time.
||They want to ensure that they can provide for their children’s college education in 5-7 years. Would like to explore the benefits of investing in equities but are concerned about the time required to research and manage their portfolio.
You need to ask yourself why do you want to invest, what your financial objective is behind your investment and when you hope to realise it. If you are saving for your retirement, for example, you may feel you can afford to be more aggressive because of this longer-term investment horizon. On the other hand, if there is a possibility you may have a pressing requirement for funds in the short term, it doesn't make sense to invest in risky, volatile stocks. Indeed, the greater the possibility of short term funding needs, the less appropriate it is to invest in equities, particularly because of the costs involved.