Equity investing: Basic rules of investing in the stock market

By P Saravanan and Sumit Banerjee

After life insurance, by and large the most preferred instruments wherein Indians park their surplus cash are fixed deposits or government savings schemes. While this allows their money to be largely secure from the vagaries of the stock market, it also keeps them away from the prospect of earning high returns. In this context, let us discuss the essentials of investing that would help investors to be ready for investing in the stock market.

Analysis
Any investment strategy is based on the analysis of the financial instruments on offer. The investor needs to understand the business of the firm whose stock he plans to buy in the market. One should understand how the company carries out its business, its strengths and weaknesses, its growth prospects, etc.

The investor should also go through the financial statements of the company and know how well the management is managing the affairs of the company. One needs to understand from where the company is generating cash and where it is being utilised. Investors must understand the prospects and the value of the firm and compare it with the current market price of the stock. If the stock is undervalued, then the investor can invest in that stock.

Look at blue-chip stocks
Any beginner in the stock market should start with blue-chip stocks. The term ‘blue-chip’ comes from the game of poker where the blue-chips command the highest value on the table. Similarly, a blue-chip company is a renowned,
well-established, and financially stable company. Investors who are new to the stock market can start their journey by investing in such companies as the risk factor is lower for such stocks, compared to mid-cap or small-cap companies. Although the mid-cap and small-cap companies have higher returns, they are also more volatile than these blue-chip stocks.

Cashing in or cashing out
One of the most important, but an often-forgotten, aspects of investing in the stock market is the exit strategy. Beginner investors tend to keep their stocks on their portfolios as their babies and do not let go even when the stock price hits the roof. This reluctance to sell a stock happens because they do not have an exit plan ready. Exit plans are necessary for both situations— stock prices moving upwards or downwards. If the stock prices move upwards, the investor should cash in after it has breached his expected returns margin. If need be, the same stock may be again purchased and kept in the portfolio, if the stock is undervalued and if it can go upwards in future.

Diversification
Though we all know the adage ‘Never keep all your eggs in the same basket’, yet it is not executed in the stock market context. Diversification is the method by which we can maintain our returns while reducing the risks of our portfolio. Diversification means investing in different companies from different industries whose prices do not move in the same direction. It also means investing in different industries which are not connected to each other. Diversification reduces the impact of market volatility in the investor’s portfolio.

We offer the above four basic rules of investing to all the beginners who wish to invest in the stock market. By following above rules one can wade through the initial challenges of long-term investment journey.

P Saravanan is a professor and Sumit Banerjee is a doctoral candidate in finance & accounting, IIM Tiruchirappalli

BEGINNER’S BASICS
Understand the business of the firm whose stock you plan to buy in the market
If the stock is undervalued but has good growth prospects, invest in that stock
Start with blue-chip stocks as they are less susceptible to market volatility
Keep an exit plan ready —both for when the stock is moving upwards and when it is moving downwards
Diversify your investment portfolio to reduce the impact of market volatility