Friday, April 3, 2009

10 THINGS WE MUST KNOW ABOUT STOCK MARKETS

Investing in stock attracts extreme reactions from people ranging from extreme enthusiasm and optimism to complete pessimism and apathy. None of this is right way of approaching stock markets. Stock markets like any other asset class do offer scope for capital appreciation within the boundary of its inherent risk reward equation.Fortunes have been made on stock markets, as Rakesh Jhunjhunwala or Warren Buffett would tell you. But for every Warren Buffett and Rakesh Khunkhunwala,we have quite a few who have lost money in the stock markets well. The key is to understand the dynamics of this market and play it well. So, for you and me , what are the things that we need to know before we trust equities with our hard earned money? I have outlined 10 such things which all equity investors should know.
1. Stock Market is a financial institution , not a casino - First thing to understand for everybody before we get any further is that stock market is a place where trading of stocks happens. It is not a casino where you make money by wagering. There is a method to even day trading that takes place on the indices and hence you must not approach stock markets just to try your luck. You might get lucky at times, but,certainly not always. If you approach stock markets like a casino then be prepared for an outcome like you get in casino.

2.Understand the risk reward ratio - Equities like all other investment class has its own risk reward ratio. Equities are supposed to be relatively riskier asset class as compared to debt based instruments like FD, bonds, Gilts etc. So people investing in equities should be aware of this fact that equity is riskier than other investment tools. And since there is more risk in equities, the chance of returns are also higher in it than other investment tools like Bonds, Gilts, FD etc. One must enter into stock markets only if he is ready to take the risk that is inherent in equity investment.
3.Past performance is not an indicatiText Coloron of future performance - This might sound cliched but the fact is that this is very critical for all investors to understand.Past performance of a particular stock or broad markets is no indication or guarantee of future performance. In other words, if the market did well in last 12 month delivering over 30% returns, it does not mean that in next 12 months it will again deliver 30% returns. The markets can under perform or over perform over next 12 months and that may not have anything to do with the way markets behaved in last 12 months. So one must make his investment decisions based on the fundamentals of the company, its management quality, its growth potential etc and not on the basis of its historical returns.
4.Know about the company you want to invest- Great investment guru Warren Buffett says that he invests in equities based on his assessment of the quality of the management running the company, the company's inherent strength and its growth potential and whether the company enjoys a consumer monopoly or not in the market.He says even if the stock markets were to shut for next 20 years , he would still invest in the same companies. The essence of this is that while investing in a stock , one must do a thorough analysis of the company, its management quality , growth potential etc. One must never invest based on a "tip". Its your money and hence you must know the company before you give them your money.
5. Trust professionals if you don't have the time - For all those who don't have the time or expertise required to follow the stock markets, companies , its financial etc, there is way out. They must trust professionals to do this job for them. One can take help of noted stock brokers/financial planners etc to help them out with this.
6.Avoid joining the herd - Warren Buffett's prescription for making money in stock markets is to "be greedy when others are fearful and be fearful when others are greedy". Or in other words, one should try and buy when every one is selling and sell when others are buying. Rakesh Khunkhunwala, the other day said in an interview that he made his fortune by buying stocks much against what others were doing before Madhu Dandwate presented his budget in 70s. He took a contrarian view and that paid off handsomely.
7.Define your goals and stick to it -Another important thing is to enter the markets with a target in mind of how much returns you want from it. Make that a realistic target and then stick to it. So for instance if your target is to make 20% returns on a stock then sell it once it appreciates by 20%. Don't wait for it to go up to 25% or 30% .Doing so will expose you to the risk of loosing even 20% gain that you have now if you waited too long.
8.Buy stocks with stop loss -Almost any trader active in stock market will tell you the importance of buying stocks with strict stop loss on it. Stop Loss is a value below the market price of the stock which is assigned to that stock at which you sell it, cutting your lossses. This ensures that you looses are within manageable limits. For example, lets say you buy Reliance at Rs 1600 and keep a stop loss of Rs 1500, then this ensures that the maximum loss that you are willing to take on tBoldhis stock is Rs 100 and not more, thereby limiting your downside risk in the stock.
9.Monitor the funds - It is not only important to invest in good stocks and build a good portfolio , its also imperative that you monitor the performance of the portfolio and each of the stocks regularly, to weed out the deadwood from the portfolio.
10.Stick to index funds - For all those who want to invest in mutual funds , index funds offer a great opportunity to invest in the markets at minimum charges. The relative performance of the index funds are same, if not better, than any actively managed fund. This coupled with the fact that the charges are lower ,makes it a better option than actively managed funds.

So, these are the top 10 things you must be aware of before trying your luck with stock markets.Please add up things which you feel I might have missed out.

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