friend of mine recently landed her first job.
She spent her first few paychecks on a new cell phone, and a new wardrobe to go with it. Then, her parents began pressurise her to save.
Her question to me was: which shares can I invest in?
When I proceeded to tell her that shares were the riskiest of all investments (bonds, fixed deposits, post office schemes, gold etc), she shrugged.
When I asked her if she even knew what a share was, she confessed she did not.
I could not blame her.
Over the last year or so, the stock market has been hogging the limelight. Companies have been coming out with Intial Public Offerings (which is when the company first makes its shares available to the public by getting them listed on the stock exchange). Everyone wants to join the party and make money.
If you identify with her, here is a tutorial to help you get your basics right. Before you invest in the stock market, you must understand what it entails.
1. You own a part of the business
When you invest in stocks, you do not invest in the market (despite what you think). You invest in the equity shares of a company. That makes you a shareholder; you now own a small part of that business without having to go to work there.
The good news is, since you own part of the company, you are entitled to a share in its profits.
The bad news is that you are also expected to bear the losses, if any.
That is why investing in shares is risky. If the company does well, you benefit. If it does not, you lose. There are no guarantees whatsoever.
2. In the short-run, the price of the share can wildly fluctuate
Let's say the company fixes the price of each share at Rs 10. This is called the face value of the share.
When the share is traded in the stock market, this value may go up or down depending on supply of and demand for the stock.
If everyone wants to buy the shares, the price will go up. If nobody wants to buy the shares, and many want to sell them, the price will fall.
The value of a share in the market at any point of time is called the 'price of the share' or the 'market value of a stock'.
A share with a face value of Rs 10 may be quoted at Rs 55 (higher than the face value) or even Rs 9 (lower than the face value).
So you might have paid Rs 15 for a share which is now quoting at Rs 12. Don't panic and sell. If it is a good company, the share price will eventually rise.
The prices will get influenced by the market sentiment and the general direction of the market. As a result, you may see short-term slumps.
3. Always invest for the long-term
The best way to make money is to buy low and sell high. This means you should buy the share when the price is low and sell it when it is high.
That is why you must buy in a bear market. This is a term used to describe the sentiment of the stock market when it is low and the prices of shares have generally fallen. The best time to sell is in a bull market, when the sentiment is high and the prices of shares are rising.
But it is very difficult to time the market. In fact, no one can do it. If we could, we would all be millionaires, wouldn't we?
That is why, when you invest in the market, it is best to invest for the long-term. Hold on to your shares for a few years before you think of selling them.
Companies increase their sales and book higher profits over the years. This will eventually reflect in the share price, so ignore the short-term slumps.
Once you decide that you are in for the long haul, you can ride over the bear and bull runs with no stress at all. Over time, the price of your shares will appreciate.
If you are getting a good price for your stock, keep selling small amounts at regular intervals. Keep booking profits.
4. Decide how much you want to invest
Always remember one basic rule in finance -- if something gives you higher returns, that's usually because it carries a greater risk.
That's the reason why not-so-good companies will pay you a higher rate of interest for your deposits.
The same reasoning goes for stocks too -- they give higher returns than, say, bank fixed deposits because they are more risky. So the amount of money you invest in the market depends on your capacity to bear the risk.
If you are young with a steady job, you can invest a larger proportion of your income in the stock market than, say your parents who are close to retirement. If you have a lot of debt to repay, avoid putting too much of your money in stocks.
It's best to decide how much of your savings you will allocate to stocks, and stick to that plan. Don't get swayed by how much your friend is investing.
5. Don't rely solely on 'good advice'
A smart investor should never invest buy shares of companies he doesn't know much about. Relying on 'advice' from friends is not always a great idea. Do some groundwork yourself.
It doesn't matter who is buying the stock or who is recommending it. Steer clear of such ways of making a fast buck. These tips will land you in a soup.
When you hear of a 'hot tip', dig further.
Take a look at the company's profit and loss statement, which would have been audited by chartered accountants.There is a wealth of information here. To understand the information in a Profit & Loss Account, read Want to buy a stock? Read this first.
Do some basic calculations on your own. The Earnings Per Share (net profit/ number of shares) and Price/Earnings ratio (market price/ EPS) should give you a fair understanding. Read How to spot a good stock to understand what these ratios mean and how to use them.
These tips should get you started. Tread cautiously though. If stocks intimidate you, consider a diversified equity fund.
A mutual fund manager will research many companies before investing in their shares. This way, you can participate in the stock market even as you leave the research to professionals.
Illustration: Dominic Xavier