Part 4: How should beginners approach investing in the stock market?

In part 1 of this series I wrote about the evolution of an investor to either a trader or a long term investor, and said that I favor long term investing to short term trading.

Then in the second part I wrote about the implicit assumption that a long term investor makes which is over a very long period of time the market will move upwards, and then also spoke about the nature of a share or stock. That nature I said was that a stock is a representation of the earnings of a company, and looking at it that way helps you stomach the volatility that exists in the market and deal with the daily ups and downs.

In the third part I wrote about regular investing, calibrating those investments and three big ideas that drive that type of investment. First one was my expectation that markets will edge higher over a time period of 3 – 5 years, second one was that markets don’t move in a linear fashion and a lot of the gains that have come in the past have come from small time periods that have surprised a lot of people so you don’t want to get out of markets completely, and finally I said that while timing is not be possible, you can vary how much money you put in the market and take advantage of falls.

I ended that post saying that I’ll deal with what are some of the instruments that you can use to execute this strategy, and that’s what I’m going to write about in this post.

ELSS Tax Saving Mutual Fund

If you want to invest in equities then ELSS funds are a great way to get started. They are one of the best options in the 80C limit since they have the lowest lock in period, and by investing the equity portion of your portfolio in ELSS, you ensure that you get some tax benefit right away which can be pretty significant if you are in the 30% bracket and the advent of some great tax free listed bonds also means that even if you don’t invest in bonds with 80C tax benefits you can still get good yields so you can keep 80C for equities.

Here is a list of good ELSS tax saving mutual funds that I updated late last year and this gives some good options that you can select one or two from.

I think ELSS funds should be on top of your list if you’re looking to get started with investing in shares.

Balanced Mutual Funds

Balanced funds may appear an odd selection when you first think about them because most of them invest about 35% of their assets in debt products, but past performance has shown that balanced funds have given returns comparable to good diversified equity funds, and that stems from the fact that the debt portion of it protects you from the sharp downturns that Indian investors have had to face many times during the last two decades, and there’s hardly any reason why that would stop from happening in the future.

Here is a list of some good balanced funds that you can choose from.

Good Diversified Funds

Hemant has a great article on some of the best diversified funds with some great comments that can be used to select a couple of diversified mutual funds to add to the balanced funds in the list above.

Nifty Index Funds

Internationally, index funds have done a lot better than active funds, I believe this is not true for India, and I’ve highlighted the reasons in this post (also read instructive disagreeing comments from Nitin).

Having said that, I feel if you are going to construct an equity portfolio, at least a small part of that should be a low cost index fund based on a large cap index like the Nifty or Sensex. I say that because costs eat into returns and index funds are lower cost (thought not as low as American funds) when compared with active funds, and have also performed decently in the past and give you the peace of mind that the fund manager won’t be screwing around with your money. The reason to stick to the big indices is that the Indian market is not very deep and volatility becomes quite high when you start moving towards the smaller caps.

These are some options from which you can consider choosing from, and as to the question of how much money you should invest – I think a little less than you are comfortable with is a good way to start.

I say that because it is hard for people to come to terms with how violently and quickly the market can fall, and how difficult it is to not panic and sell when you own funds that have gone down 15% or 20% in a month or two. Getting into the market with lower amounts will ensure that you’re able to deal with this volatility and get a grasp on how you feel about the market and feel more confident going in with bigger sums later on.

If you’re starting off then it is likely that you are in your twenties and still have a good 30 – 40 years of investing ahead of you, don’t rush to put all in and then later find out that you weren’t ready to risk that much money. More than losing the money, it will turn you away from the market completely and that means you lose out on what is potentially a great opportunity to steadily grow your money in years to come.

This is the last post of this series, and I must admit this was a lot harder than I thought it will be and took a lot longer than I thought it would take, so if you found it useful please do forward the links to your friends, and as always, all comments are welcome!


7 thoughts on “Part 4: How should beginners approach investing in the stock market?”

  1. A really well-written article for long-term investors. But, I too wanted to know more about investing in stocks directly rather than investing through MFs. Can elaborate on the technical and fundamental analysis that you talked about in the intial post? Before investing in a certain company what sort of analysis should be done? Going through the annual reports etc. Thanks in advance!

  2. Read part 1,2,3 and 4. Very informative. Thank you.
    But I was hoping to learn something about investing directly in stocks (not indirectly through mutual funds).
    Suggestion please?

  3. One important aspect Manshu highlighted in his post 3 is not timing the market and still have a strong investing inclination when there is doom and gloom. By the time there is any convincing clue that we are not in a downtrend anylonger, the market would have moved 15 – 20% from the bottom. If you wait for this clue to invest, that can be more troublesome.
    For example, there was a lot of gloom and doom on Dec 20 2011. If you waited till Feb, market had move up 15-20%. If you would have started investing then, you will be worse off now, since you would have already lost 15-20% and there may still be more.
    So if you have not started yet, this is the best time to start. If the market drops another 20%, invest some more! The risk reward ratio for an investor becomes more favorable as the market dips more.
    Manshu, I liked your comment “Invest a little less than what you can stomach”. Words of wisdom! And that “little less” helps when there is a further downtrend without having to watch helplessly when equity becomes more mouth watering!

  4. Nice article. i initially thought it to be quite exhaustive but as i went on reading, i did enjoy the content. Index funds are not promoted, same is the case of term insurance. Both lack the charm as they are not showcased properly.

    Index funds are best bet when the market is very volatile.

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