How does a first-timer tread the stock market with caution?

Three things you should know before jumping into the stock market

With a record number of demat accounts being opened in the past two years, the stock market is at the centre of everyone’s attention. Changing technology, cheap mobile data and user-friendly apps are pushing more and more people into the market. It doesn’t help much that fixed deposit rates aren’t very high and that the stock market has been scaling new highs since the Covid-19 pandemic-induced days of March 2020. However, with the hope that the worst of the pandemic is behind us, and countries across the world looking to get back to normalcy, the stock market is also taking a reality check.

This rough weather afflicting the stock market stems from concerns over recent events such as the hike in interest rate in the United States and Russia’s attack on Ukraine. In India, while the economy is gradually recovering from the pandemic, there are apprehensions stemming from global factors such as oil prices hitting US$100/barrel, a surge in commodity prices and the impact of these runaway prices on inflation. So if you’re entering the stock market for the very first time right now, you should be careful; after all, stock markets have a way of surprising almost everyone. Here are three things that should help you on the way.

1. Stock markets are for traders and investors–where do you fit?

Stock trading and stock investing are two different things; people can be full-time traders as well as investors. You need to be clear about why you are investing in the market. While both activities seek to make profits from the stock market, trading and investing are fundamentally distinct, and the skill-set required for both differ too. People with a very high-risk profile who can understand and bet on minute-to-minute, day-to-day movements in the stock market usually veer towards trading. Investing, on the other hand, is for those who can wait for the long term–a minimum of five years–for their portfolio to perform. The first step, then, is to understand and assess your risk-return profile. A common question that advisors ask is: how will you react if you lose more than half of your money in the stock market in less than three months?

Stock trading is not for the faint-hearted and there is evidence to prove that very few stock traders make meaningfully large amounts of money. Don’t go by the success stories of traders like George Soros. Soros and other veterans have withstood many battles that most people wouldn’t have the risk-appetite for. Investing in stocks, however, has a longer time-frame, and there is evidence to show that the longer you stay invested in the market, the lower your chances are of making losses. All this does not mean that the stock market is guaranteed to make you money–nothing is guaranteed in the stock market.

2. Stocks or mutual funds?

There are two ways to buy stocks–directly through an equity broker or indirectly through a mutual fund. When you buy stocks directly, you own shares in the company. On the other hand, when you buy a mutual fund, you own units of the mutual fund, which, in turn, owns the shares of many companies. Equity mutual funds are entities created to pool together money from many investors to invest in stocks. Equity mutual fund schemes are run by fund managers and their teams who track the stock market and conduct in-depth research on stocks. So while you might also track the stock market and do your research, your capabilities as an individual are limited–you might have a day-job which probably limits the amount of time you have at hand. Mutual funds are, therefore, ideal for investors who don’t have the time or resources to track the market.

Equity mutual fund schemes are classified on the type of stocks (large cap, small cap or mid-cap) they invest in as well as other factors such as sector (MNC Fund or Banking Fund) and theme (Infrastructure Fund or Pharma Fund). It is then important to understand the mutual fund that you want to invest in and whether it fits your risk-return profile. Similarly, if you want to do your own research and buy stocks directly, then you must develop a framework and methodology that fits your risk-return profile.

3. Active or passive investing?

Within mutual funds, there are two broad styles of investing– active and passive. Passive investing means simply buying the constituents of an index while active investing involves buying stocks based on the fund manager’s choice. An index is a group of stocks around a specific theme or factor–so the NSE Nifty 50 or S&P BSE Sensex 30 are indices consisting of the 50 (for Nifty) and 30 (for Sensex) largest (free-float adjusted) stocks in India. There are similar indices for mid- and small cap stocks and for factors such as momentum, alpha, volatility and so forth. In passive investing, a fund manager simply buys the stocks represented in the index. As the constituents of an index change (called rebalancing) during the year, so does the portfolio of the index fund. In active investing, the fund manager uses their own philosophy to invest in stocks. For example, a fund manager might believe in value stocks or growth stocks and thus invests in the stocks that they believe fit into a value or growth framework. In active investing, therefore, the portfolio of the scheme changes as per the decision of the fund manager running the fund.

The most significant difference between active and passive investing is cost. Passive mutual funds typically charge lower fees than active mutual funds, simply because the cost of tracking an index is lower than the cost of researching and choosing individual stocks to find the right stocks to invest in. Detailed studies of the past few years have shown that a majority of active funds underperform active funds. Hence, passive funds offer a low-cost and transparent way of being invested in the long-term model of the stock market.

Finally, if you have decided to invest in stocks, the first step is to choose a good broker. While doing so, you must consider factors like their registration number and license, reputation (in terms of who owns the brokerage), quality of service, how good is their mobile app, customer support, commissions, costs and scope of service (do they provide you with stock ideas, research reports, or, in case you don’t need that, are they only for execution of your trade?). Choose your brokerage with extreme caution and be careful with the agreement that you sign on. For instance, never give a power of attorney that allows the brokerage to make decisions on your behalf. Building trust with your broker is crucial in order to maintain a long-term association with them for your financial planning.

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