In our earlier article, we discussed many investment options in which you can park your money based on your goals - FDs, RDs, NSC, NBFC deposits, mutual funds. But what about the stock market? With a bull market on, many folks around you seem to be making (or claiming to make) big returns from stocks.  

The social media is full of folks claiming that the ₹10,000 they invested in so-and-so stock has today turned into many lakhs or even crores. But they sure don’t tell you about the many stocks where they invested ₹10,000 and lost their shirt!  

The main thing for investors to understand, before stepping into the stock market, is that this is an asset that can multiply your money, or decimate it, depending on your timing and stock selection skills. Investing directly in stocks is not for everyone. To do it successfully, you need four attributes.  

Risk appetite  

Usually, when you ask a new investor if they can take risk, you get a vociferous ‘yes’. But that’s because they may not be thinking of risk in the correct terms. Though there are many textbook methods to assess risk, the most practical one is to honestly assess how much capital you’re willing to lose. In other investments like bank FDs or post office schemes, you may make a lower or higher return but you (mostly) don’t lose your principal. In stocks, losing your principal is a commonplace occurrence.  

So the first thing you need to invest in stocks, is the ability to take losses to your principal. Veteran investors will tell you about market crashes like the one in 2000 or 2008 where they lost 80 per cent or 90 per cent on some of the popular stocks of the era. Even if you manage to avoid such mishaps, if you invest in an overheated market, you can lose 40-50 per cent of your capital. Don’t forget that the Indian market, at the index level, fell over 50 per cent in 2008 and over 40 per cent in 2020.  

Read: MFs find hard to retain SIP investors

You should be investing directly in stocks only if you have the appetite to take big losses in the short run. And you should only bet that amount of money on stocks, where you can afford to lose 40-50 per cent.    

Ability to hang on  

If the markets have the habit of crashing by 40-50 per cent sometimes, how do some people make big returns on stocks? Well, they do it by simply hanging on through these crashes and waiting for the next bull market to arrive. Stock prices move in cycles. But in the long run, they keep up with the earnings of companies that make up the market. In a growing economy like India, stocks tend to face high short- term volatility but over the long run, if you look at the Sensex or Nifty graph, the big crashes are blips on the radar.  

Read: How to think about stock weights

For you to brush off the big crashes and view corrections as mere blips to your portfolio, you need to hold stocks over a long horizon. Now some folks may tell you that a 3 year or 5 year holding period is enough to mint money from stocks. But a more realistic horizon to survive crashes and to come back, is 7 years or more. Investors who lost money in the dotcom crash of 2000 had to wait until 2004 to get back to break even. Those who invested in end-2007 had to wait until 2014 before they could get back to the green. So while investing in stocks, be prepared not to take that money out for the next 7 years or more.   

Knowledge of business and finance  

The examples that you see of banks, paint companies etc multiplying some investor’s money in ten years, are loaded with survivorship bias. What’s that? These are examples of stocks that survived market crashes and made it out unscathed. And therefore were able to multiply money. For every paint stock or consumer stock that has gone up 5 times or 10 times, there are dozens of examples of infrastructure stocks or power stocks that have made investors’ money disappear in the last 10-15 years. It is not easy to know, without the benefit of time travel, which stocks will make it big over the next ten years, and which will vanish without a trace.    

The only way to get good at this prediction is to understand the business you’re investing in like the back of your hand. When you invest in a stock the main call you’re taking is that the company will manage to multiply its profits over time. Evaluating this requires the ability to understand industries and business and economic cycles, apart from the profit drivers and risks to the business you’re investing in. To identify rogue companies, you need serious balance sheet reading skills. To estimate where a company’s profits may go in future, you need forecasting and modelling skills.  

Read: What are good, bad and terrible loans?

So to cut a long point short, direct investing in stocks requires knowledge of business, accounting and math, to some extent. If you don’t have these, your hit rate with stocks is likely to be poor.  

Time to spare  

Finally, many folks think of making money from stocks as a sort of hobby, a part-time endeavour. But to be really successful at investing and trading, markets, companies, businesses etc need to be your passion. Look at any successful investor or trader and you’ll see that they are professionals, fully immersed in this world of companies and markets 24/7. To earn good long term returns from stocks, you need to track their financial performance, corporate actions, competitors and also external factors like policy and regulatory developments.  

Few folks with a full-time job will have time or the energy to do all this. That’s why mutual funds have become so popular! Our next episode will tell you about how this friendly vehicle can be a lazy way to make money.