Things to Know Before Investing in Stock Market

If you are rightfully excited after opening your trading account and demat account with your broker, you are entitled to be so. After all, you are going to make your foray into the esoteric world of equity markets. Most likely, you have heard fascinating stories of how companies like Wipro, Infosys and Eicher Motors created incredible wealth for its investors. Before you embark on your first equity investment, here are 11 things you must be absolutely clear about. That will allow you to be more pragmatic and realistic in your expectations from your equity investments.

You can never really catch the tops and the bottoms of the market

This is something a lot of first time equity investors try to do. They believe that you can make money only if you buy stocks at the bottom and sell at the very top. You need to understand two things. Firstly, even for the most seasoned of investors catching the tops and the bottoms of the stock price is almost impossible. Even the likes of Warren Buffett have admitted to that. Secondly, catching the bottoms and the tops really does not matter over time. In fact, studies have shown that even if you really catch the bottom and top of the stock markets, your advantage will only be marginal over time. Then why worry about that in the first place.

Never get into a trade without a stop loss and profit target

Any trade or investment made by you is a risk-return trade-off. That means for a given level of returns you are only going to take so much risk. Even when you invest for the long term, there is a mental stop loss you require at which point you will reverse your position. It could be a structural issue with the company or the maximum capital you are willing to risk on the stock. Similarly, have a profit target in mind. Of course, you can keep extending these targets, if the situation demands, with the help of trailing stop losses.

Keep a tab on company news and set smart alerts

It is not just enough to invest in a company’s stock but you must also be in a position to monitor your investments. Once you have invested in a company, keep a tab on earnings announcements, corporate actions, industry specific news, company specific news, new innovations in the industry etc. Smart investing is about setting alerts and monitoring the ecosystem around your investment.

You will typically make profits in equity only in the long term

This is something you must be clear at the very outset. There are odd occasions when your investments will double in 3 months. These are the exceptions not the rule. Ideally, equity investment will yield attractive returns only over a period of 3-5 years. Keep your patience levels high and take a long term perspective.

Respect companies that pay taxes and dividends

What is so special about companies that pay dividends and taxes? Simple, it is an indication that the company actually has cash to pay taxes and dividends. There are a lot of things that can be done with creative accounting, but when a company pays its taxes and dividends regularly, it is one of the best indications that the company is solvent and is also liquid.

When it comes to investing, value matters more than price

Don’t give too much credence to prices. Some stocks might be trading in single digits and some might be in 5 digits but the inference because a stock is trading in single digits and the notion surrounding perceived value towards such stocks might be illusionary. There are obvious inherent reasons why the stocks are trading at such low value and valuations. Don’t be obsessed with low P/E stocks; probably that is what they are worth.

Don’t ignore the impact of taxes and transaction costs

Dividends and capital gains have tax implications. Dividends attract DDT and also 10% tax above Rs.1 million per year. Short term capital gains are taxed at 15% while LTCG is taxed at 10% without indexation above Rs.1 lakh in a year. Taxes make a big difference to your effective returns. Similarly, transaction costs like brokerage, turnover fees, GST, stamp duty and STT also matter in the long run.

Prefer companies with low debt and low equity base

This should be a guiding principle for your equity investing. Over the long term, the companies that create value are the ones with low debt and low capital base. That explains why IT companies like Infosys and TCS created tremendous wealth. A low equity base means that your profits are going to be distributed across less number of shares. That enhances valuations.

Learn to control your emotions

The secret of investing is to buy when others are fearful and sell when others are greedy. Never panic in markets because, that way, you will subsidize the other investor who does not panic. Never take investment decisions in a state of fear or optimism; you are more likely to be wrong. Always separate your emotion from your judgement when you are buying or selling equities.

Never borrow to invest in equities

That is the cardinal sin. As Keynes said, “Markets can be irrational much longer than you can remain solvent”. You do not want the dual pressure of MTM losses on your equity holdings and regular commitments on your borrowings. Using a certain outflow commitment to finance an asset with uncertain cash flows and price movement is never a great idea.

There is merit in diversifying your risk

Great investors like Buffett, Soros and Lynch have spoken about the merits of concentrating your portfolio. But as a rational investor you need to get the benefit of diversification. You need that to spread your risk across assets with low correlation so that you are protected in market cycles. That will ensure that your risk is in control.

These 11 points are a good starting point for you to start your journey into equity markets. If you take care of these small things in the market, the larger issues will take care of themselves.