Important things to know before investing in the stock market

Investing in the stock market comes with its own risks. These pointers can help you make better investment decisions

Important things to know before investing in the stock market

Investment in equities is lucrative as it has the potential for high returns. It’s known to beat inflation over long periods; historically, equity investment has generated returns close to 14-15% CAGR (compound annual growth rate) over the long term (15 years). 

However, equity investment can be risky. The good news is the risk can be mitigated. To make decisions in tandem with your risk appetite and investment goals, the following pointers will be a good reference as you start investing in the stock market.

Structure of the market – exchange, participants, and intermediaries

You would already know that investing in the stock market involves trading (buying and selling) shares of publicly listed companies on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). The Securities Exchange Board of India (SEBI) is the regulator that sets the legal framework and oversees all entities operating in the market. Apart from you, a domestic retail participant, other participants in the stock market could include:

  • Non-Resident Indians (NRIs) and Overseas Citizens of India (OCIs) – individuals of Indian origin but based outside the country
  • Domestic institutions – large corporate entities such as LIC and asset management companies (AMCs) based in India.
  • Foreign Institutional Investors (FIIs) – non-Indian corporate entities such as overseas AMCs, hedge funds and other investors

Related: How to clean up your investment portfolio? 


Mechanics of trading

Let’s assume you wish to buy 100 shares of a company XYZ. You place an order through your trading account at a certain price. Your order ticket reaches the stock exchange, where the search begins for a seller willing to sell shares of XYZ at the price you quoted. On successful completion of the search, the trade is executed, and the shares are electronically credited to your demat account and debited from the seller’s demat account. As the new owner of these shares, you are entitled to dividends, stock split, bonus, rights issue, voting rights etc.

As you continue to buy and sell shares, it helps to learn about the state of the economy, industries, and firms. For this you can refer to the stock market index, which acts as a barometer – rising when the market participants are optimistic and falling in the wake of pessimism. Sensex and Nifty are the two main indices you can refer to for information, benchmarking, trading, and hedging.

Related: Bond ETFs may soon be a part of the Indian financial markets 

Common terminologies

Being familiar with stock market vocabulary is essential for you to trade successfully and be a better investor. Here are some terms you should be familiar with:

  • 52-week high/low: A range within which the stock has traded during the last 52 weeks
  • All time high/low: A range within which the stock has ever traded since its listing
  • Ask/Offer: Lowest price at which an owner agrees to sell shares
  • Averaging down: Buying more of a stock as the price goes down to reduce the average purchase price
  • Bear market: A market situation where stock prices fall consistently
  • Beta: A measurement of relationship between the stock price of any particular stock and the movement of the whole market
  • Bid: The highest price you are willing to pay for a particular stock
  • Board lot: A standard trading unit defined by a particular exchange board
  • Book: An electronic record used to manage all the pending buy-and-sell orders of particular stocks
  • Bull market: A market situation where the price of stocks increases rapidly
  • Close price: The final price at which a stock is traded on a particular trading day
  • Cost averaging: Buying a stock in tranches instead of lump-sum to help reduce the average cost of investment,
  • especially when a stock falls after buying it
  • Day trading: The practice of buying and selling before the close of the markets on the same day
  • Delivery trading: Taking delivery of stocks in your demat account with sufficient funds to afford the purchase
  • Direct Public Offering or Direct Placement:[i] A company may offer stock directly to the public to raise capital without any intermediaries – investment banks, broker-dealers, underwriters – typically in an IPO. Eliminating intermediaries and self-underwriting substantially lowers the cost of capital and is therefore attractive to small companies and companies with an established and loyal client base
  • Hedge: Used to limit your trading losses by taking an offsetting position
  • Insider trading: Illegal share trading based on confidential knowledge
  • Initial Public Offering:[ii] A company seeking capital to expand or become publicly traded offers its stock to the public for the first time. It then procures the services of an underwriting firm or investment bank to help determine the offer price, amount of shares, and timeframe for the market offering
  • Intraday position: A trading position you start to square off the position the same day
  • Limit order: Mentions the buying or selling price at which the order will get executed
  • Listed company:[iii]A company whose shares are traded on the stock exchange as it complies with the exchange’s listing requirements
  • Long position: Buying (or intending to buy) shares of a company 
  • Muhurat trading: A special hour-long trading session conducted on the BSE, usually in the evening, on the occasion of Diwali
  • Margin trading: Trading with borrowed funds or securities. While it has the prospect of high returns as it actively seizes market opportunities, there is high risk involved – such as interest payments charged for the borrowed money
  • Margin: Difference between the amount of the loan and the price of the securities
  • Market capitalisation:[iv]The aggregate valuation of the company based on its current share price and the total number of outstanding stocks. It is calculated by multiplying the current market price of the company’s share with the total outstanding shares of the company. One of the most important factors that can help investors determine the returns and the risk involved
  • Market order: Placing an order for share trade at the prevailing market price
  • Moving average: A stock’s average price-per-share during a specific period of time
  • One-sided market: A market that has only potential sellers or only potential buyers but not both 
  • Price target: The maximum price a share could rise to. You may look to sell at the price and earn a profit
  • Quote: Information on a stock’s latest trading price. This is sometimes delayed by 20 minutes unless you are using an actual broker trading platform
  • Rally: A rapid increase in the general price level of the market or of the price of a stock
  • Rolling settlement: Trades executed during the trading day (T) are settled within three days – trading day plus two working days (T+2). So, on the third working day the shares bought will appear in the buyer’s demat account. Markets are open from Monday to Friday
  • Sector: A group of stocks that are in the same business
  • Short-selling: When in anticipation of a fall in a stock’s price you borrow a share to sell it. After the fall, you buy back the share at the low price to return it and make a profit consequently. If the share price increases instead, you end up with a loss
  • Spread: Difference between the bid and the ask prices of a stock
  • Square off: Close an existing position, i.e. sell the stock if you’re long and buy if you’re short
  • Stop loss: A target on the lower end to sell before the price falls further and worsens the loss
  • Upper/Lower circuit: A price band set by the exchange within which the stock can be traded in the market on a given trading day 
  • Volatility: Price movements of a stock or the stock market as a whole. Highly volatile stocks have extreme daily up and down movements and wide intraday trading ranges 
  • Volume: The number of shares of stock traded during a particular period, normally measured in average daily trading volume
  • Yield: The measure of the return on an investment that is received from the payment of a dividend (= annual dividend / purchase price)

Related: Clueless about investing in stock markets? Here are some options 

Basics of stock selection and valuation

Just as one bad apple can spoil the whole lot, poor performing stock(s) can offset the gains from others and bring down the value of your portfolio. So quality matters while picking a stock and at a right price. Here are some basic concepts to guide you:

  • Top-down (stock selection) approach: You start by taking into consideration the macro-economy, followed by industries, and finally the company. As a first step you should understand the trends and outlook for the overall economy. In this backdrop, you run an in-depth analysis on industries to shortlist those expected to thrive. Accordingly, you identify the players, competitors, and other factors that affect the industry. Then you pick a company and its stock for investment.
  • Bottom-up (stock selection) approach: You focus on the company’s fundamentals based on your priorities – either high growth or steady income. You select a set of stocks, analyse them, and select one that best fits the requirements. This is most apt for weak market conditions as it brings out anomalies; companies that don’t follow the normal market trend often perform better.
  • Fundamental analysis: Before investing, you analyse the company’s financial earning and ratios, expansion, future plans, management, foreign investment/collaboration, and valuation. 
  • Technical analysis: You study the movement of the share’s open, high, low, and closing prices. You also make use of volumes, support and resistance levels, technical indicators, and other parameters to analyse share price movements in short-term or in day trading.
  • Absolute valuation: You try to ascertain the intrinsic value of the company based on its estimated free cash flows discounted to their present value. The approach involves making a few assumptions and the outcome is as good as your underlying information.
  • Relative valuation:[v] You use financial ratios to compare the company’s value with its competitors to find its value. As the approach assumes correct valuation by the market, if all the companies in an industry are overvalued, the result is misleading.

Related: All about IPOs in India

Conclusion

These basic concepts should be a good resource to get started. Patience and discipline while investing in the stock market will help you gain wisdom. As you gain experience and acumen to sense the pulse of the market and take calculated risks, you can eventually build a portfolio that outperforms the market.


 

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