Part 2: How should beginners approach investing in the stock market?

by Manshu on March 26, 2012

in Investing for Beginners

In part 1 of this series, I wrote about how most people get hooked to the stock market and how they evolve through the various stages of a speculator / investor.

I closed that post summing up my preference for long term investing, and in this post I’m going to write about two things that I feel are particularly important. First is an implicit assumption that long term investors make and second is how you should view a share or a mutual fund.

I think it bears mentioning that there will be a third part of this series as well.

The Assumption

If you are a long term investor you should recognize that there is an implicit assumption in what you’re doing, and that implicit assumption is that over the long term the stock market will go up.

The stock market is a barometer of the economy, and if the GDP rises then the stock market indices will also rise with it. About a year ago, Mr. Mukesh Ambani said that Indian nominal GDP could cross $30 trillion by 2030, and if the economy were to roughly grow at 15% – 16% in the next 20 years – I think the target will be met. Now, remember this is the nominal GDP growth rate (which doesn’t take into account inflation) and not the real GDP growth rate and that’s why it sounds high, but in reality this is close to the nominal growth we see today.

So, if the economy were to grow to 15 times its size in the next 20 years, you can expect the stock market to grow along those lines as well. There won’t be a perfect correlation, but if the economy grows then the stock market should rise as well.

By and large most stock markets have shown this to be possible, but there are exceptions like Japan whose stock market is just 20% of what it was 30 years ago and then there are long periods of time when the Dow didn’t move anywhere at all.

In India’s context, I think the risk is more political than anything else. If the political class doesn’t screw up policies and business environment then this growth should be attainable. From recent experience, we know that they are capable of screwing it perfectly well.

It’s important to understand that long term investing does rest on this assumption because if you don’t understand this then you can be lulled into thinking that the market will always go up no matter what so it is safe to have all of your cash in the stock market. There is no guarantee that the market will always go up so it is best to have a portfolio that is diversified between shares and fixed income products.

The next thing that I think is important from the perspective of a long term investor is to understand the nature of a stock or share – to know what is it that you are buying or selling.

What is a share?

Long term investors and traders view a stock or share very differently. While traders are more concerned with the price and volume action of the stock, long term investors are concerned about the underlying business of the company.

They view the share as part ownership in the company and the correlation in their mind is between earnings and share price. If the company continues to grow profits many years down the line then the stock price will also rise to match that growth.

If you think of stocks like this you will start thinking of expensive or cheap stocks with relation to the money they make. So, when you look at a company you will think in terms of how much money the company makes (earnings or free cash flow) and how much it is selling for (market capitalization) and base your value decision on that.

A lot of investors will never buy individual stocks and there’s good reason for that but even then you need to be able to view stocks in this way to stomach the inevitable volatility that exists in the market. This outlooks helps stomach volatility because when the market falls by 20% or 30% in a short period of time you are able to look at the earnings of the companies whose shares have fallen and say to yourself, surely this company will not go bust and the stock price will not go to zero.

I believe this kind of outlook helps people deal with the volatility that has been part of the Indian markets for very long and will most likely continue to exist in the future as well.

Even if you buy mutual funds – it is the same thing since a mutual fund in turn holds shares and it is nothing but a representative of the value of the shares that the fund holds.

This of course is not true if you’ve been buying penny stocks or hot stocks which can go down very fast, and then never recover, but if you have been steadily buying decent stocks over a long period of time then this will hold true.

So, to sum it up, long term investors do rely on the somewhat obvious (even if unspoken) assumption that in the long run, the market will move upwards and you have to view a share as part ownership in the company to be able to truly appreciate what you are buying.

Next, Monday I’ll have the third part of this series and if you haven’t read the first part which deals with how people get hooked to the markets and how they evolve through different stages, then I recommend you read that as well.

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