The benchmark BSE Sensex on Friday crossed the psychological mark of 20,000 and closed at 20,039.0. The stock market had a good run in 2012, too, with the Sensex posting 27% return and if the experts are to be believed, the environment for equities is expected to remain favourable in 2013 as well.
There are expectations that economic growth will bottom out, interest rates will ease and liquidity in the marketplace will remain comfortable, even though macroeconomic risks have not completely abated.
With this kind of backdrop, it is only natural to get attracted to equities as an asset class. However, even in a favourable market environment, it is important to follow a few basic rules to market investing.
Here are five rules that will help you make a start and generate wealth in the long term.
Look at large-caps
It is always advisable for retail investors to start with large-cap names due to a variety of factors. First, there is a possibility that you are familiar with the name and have some idea about the business of the company. This will ease things quite a bit compared with spending time in understanding a new and unfamiliar company.
Second, large companies are comparatively easier to monitor as they are normally well tracked by analysts and the press.
Third, normally, the price volatility is lower in bigger names than smaller companies and gives the much needed time to retail investors to adjust as managing investment and tracking markets all the time may not be feasible for a majority of retail investors.
However, it needs to be underscored that the size of the company offers convenience and does not guarantee higher returns. Even when investing in a large-cap company, it is important to understand its business and future prospects.
"Since markets are at a two-year high, there is a natural temptation to invest, but investors should do proper due diligence before investing in any company," said Gajendra Nagpal, founder and chief executive officer, Unicon Financial Intermediaries Pvt Ltd.
Valuations are important
Buying a good company may not necessarily be a good investment all the time. "Everything is good for a price," said Jagannadham Thunuguntla, strategist and head of research, SMC Global Securities Ltd.
Thunuguntla explains through an example: We know apples are good for health but may not pay Rs.1,000 for it. Therefore, price is very important and should always be seen in context of earnings of the company.
A share of company X available at Rs. 100 is not necessarily cheaper than shares of company Y available at Rs. 1,000. If the earning per share, or EPS, (net profit divided by total number of shares) is, say, Rs.10 for company X and Rs.200 for company Y, the price-earnings multiple (share price divided by EPS) will be 10 for company X and 5 for company Y.
Therefore, in this case, the share selling at Rs. 1,000 is 50% cheaper than the share selling at Rs.100.
P-E multiple reflects the number of times the market pays for the EPS. So, lower P-E is considered better. However, there could be exceptions. In case the prospects of a company are not good, there are chances that prices may fall taking the P-E down. Conversely, if the P-E is higher, usually the market expects earnings to improve.
But very high P-E is best avoided. For example, if a company is selling at a P-E of 50, the earnings will have to grow by 50% to maintain the ratio and it is practically difficult to maintain such growth rates.
Invest for the long term
Retail investors should enter the market with a long-term view. "There should be clarity of objective," said Motilal Oswal, chief managing director, Motilal Oswal Financial Services Ltd. Oswal explains that problem arises when investors start behaving like traders and that is when they get trapped.
As short-term trading can be risky, and also requires time and skill, it should be avoided by small investors.
Equity is a long-term asset and should not be bought by short-term funds. In other words, you should not be investing in equity with funds that you may need in the next three years.
There is a chance that the market falls in the short term and yet you may be forced to exit when the funds are needed.
"Investors should be prepared that prices can go down and should not panic if the stock goes down by 10-15%," said Nagpal. Also, you need to give time to the company to perform-time for earnings to grow which will eventually get reflected in the share price.
Learn to accept mistakes
It is possible that some of the stocks you picked do not perform. It is also possible that the financial performance of a couple of companies in your portfolio starts deteriorating and that gets reflected in the share price.
In short, if the assumptions that you made before entering the counter begin to fall apart, you should be ready to reconsider your decision.
It is good to get involved in tracking a company, but getting attached to your buying decision is not a good idea. If the performance of the company is not up to your mark, it is good to cut losses and get out.
In order to minimize the damages of a bad selection, investors should have a diversified portfolio. If you have put all your money in only one company, the damage will be higher.
For example, if you invested Rs.100 in company X and its price fell by 20%, you lose Rs.20. However, if you had a portfolio of 10 companies and invested Rs.10 in each, including company X, a 20% fall in the price of company X will only result in 2% loss at the portfolio level.
Once you have identified the stocks to invest, experts suggest that you take a staggered approach and not buy at one go. Such an approach gives you the opportunity to buy at lower levels in case there is a correction in the market.
Also, it makes sense to buy as you gain confidence in the company and have seen its performance for a considerable period of time.
Mint Money take
There is no winning formula in the stock market, but a disciplined approach with a focus on fundamentals will help you maximize gains in the long term.
Investors should never enter the market to make money in the short term based on some tips. If research and tracking companies looks difficult, take the mutual fund route for investing in equities.