Chapter 2: Equity Investments.

2.1 Introduction to equity investments

Equity investments mean purchase of stake in a company and therefore, partial ownership of that company. Equity represents their respective ownership interests in that business. Business owners can raise capital by selling their equity or ownership interests in the business to other investors. Investors buying the ownership interest (or equity) of a business, enjoy the gains and losses of business activities and are known as shareholders. 

For example, if you purchase the shares of Reliance Industries, it means that you have become a shareholder and partial owner of Reliance Industries.

 

Importance of equity investment

Basis historical data, equity has demonstrated the potential to outperform against returns offered by some other asset classes like Gold, Debt, Real Estate, etc. It is more likely to help an individual achieve their financial goals and beat inflation and taxes in the long-term. If you invest entirely in conservative investment avenues like deposits, it may be difficult to protect your wealth from inflation and taxes.

Let's understand this with an example:

Assume that a fixed deposit (FD) offers you a return of 6% and the tax rate is 30%, then your post-tax return in hand is 6*(1-0.3) = 4.2%. If we assume equity post-tax return as 10% p.a., then after 20 years, the value of the Rs. 1 lakh in FD investment would be Rs. 2.28 lakh, while equity investment value would be Rs. 6.73 lakh, which is more than double the return of the FD investment.  

 

2.2 Risk and returns from equity investments

Equity returns

Equity returns depend on many factors that include domestic and global economic factors, inflation, interest rate, political environment, etc. Historical performance indicates that returns of broad equity indices are in the range of 12-15% p.a. However, these returns can vary from stock to stock. Stock portfolio returns also depend upon the investment time horizon and portfolio diversification. Longer the duration, higher the chances of positive and better returns. Diversification can help reduce the risk of the portfolio.  

 Risk associated with equity investments

The biggest risk in equity investment is the probability of loss of capital and non-guaranteed returns. Because of the high risk, equity also has the potential to provide higher returns.

Risk is of two types: systematic risk and unsystematic risk.

Systematic risk is also known as market risk which impacts all the stocks in some way. The economic and political environment, interest rate, inflation, etc. are examples of market risk.

Unsystematic risk is company-specific risk which is particular to a certain company or sector and this can be reduced with diversification. Financial default, strike, and management failure are examples of unsystematic risk. It is advisable to create a diversified portfolio to minimize unsystematic risk.

How to minimize the risk of an equity portfolio

There are three golden rules to minimize the risk of an equity portfolio:

1. Invest for the long-term

2. Diversify your portfolio

3. Invest periodically through Systematic Investment Plans (SIPs) instead of lump sum

 

2.3 How to start an investment in equity

 Ways to invest in equity

Primarily, there are two ways to invest in equity:

 1. Direct investment in stocks of companies
 2. Investment through equity mutual funds

 If you are a beginner, you can take advice from your financial advisor or look at research recommendations from brokerage firms to choose the best stocks as per your need. Alternatively, one can start investing in mutual funds that employ the services of a qualified fund manager to professionally manage your funds.

 

Different types of accounts required to start directly investing in stocks

To start direct equity investment in stocks, one should have a trading account, a demat account, and a bank account. You can open up a trading account with any stock broker and demat account with any Depository Participant (DP). The purpose of a trading account is to buy and sell securities, while a demat account is used for holding your securities in electronic form.

How to get returns from equity investments

There are two ways to get returns from equity investments:
 1. Dividend: Dividends are periodic payments made from the company's profits to shareholders
 2. Growth: The price of a stock appreciates commensurate to the growth posted by the company, resulting in capital appreciation
 

For example, if you have purchased a stock at Rs. 100 and after a year, sold it for Rs. 120 and received a dividend of Rs. 3 during the year,  then your total return is Rs. 20 + Rs. 3 = Rs. 23 i.e. 23%.

 

How do prices of equity shares move?

Stock prices change every day due to market forces, i.e. because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there will be greater supply than demand, and the price will fall.

But there are other factors that drive stock prices too. We can categorize these factors into

  1. Internal factors
  2. External factors
  3. Market sentiments

 Internal factors include earnings of the company, growth in earnings, company management, etc.

External factors include economic conditions, industry scenario, inflation, interest rates, etc.

Market sentiments deal with the behavioral aspect of market participants - how they react based on a stock’s future growth prospects.

 

Bull and bear markets

The terms bull and bear are used to describe market performance. The stock market is in a bull phase when stock prices are rising and investors expect that the rise in prices will continue in the long-term. Conversely, in the bear phase, stock prices are falling and market sentiments are negative and investor believes that this downfall will continue. Usually, bull and bear markets move in cycles and each cycle will continue for around one-three years, but sometimes, they may stretch for longer periods.