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Basics of Investing: Stocks

Have you ever dreamt of owning a part of Infosys or Reliance Industries? With stocks you can.

Stocks are basically 'shares' of a company. It is ownership in the most literal sense: you get a piece of every desk, filing cabinet, contract and sale in the company. Better yet, you own a slice of every rupee of profit that comes through the door. The more shares you buy, the bigger your stake in the company.

Stocks are the means by which companies obtain additional financing for their businesses - by selling off parts of their company to investors. The price of a stock can vary tremendously, from less than a rupee of a share, to a few thousand rupees a share!

How is the price of a stock determined?

It's all about the company's earnings. Suppose you own a company which makes Rs. 1,000 in profits every year. How much would you be willing to sell the entire company for? Say you ask for Rs. 10,000. Would anyone buy it?

To a potential buyer, he will assess his situation with this question, "How much return can I get if I invested my money somewhere else?"

If he buys your company at Rs. 10,000, he is essentially investing in a vehicle that can generate 10% returns a year. If he can't find that kind of return somewhere else, he will pay your Rs. 10,000 asking price. If he can, then he won't. You might have to lower your asking price.

Another factor that enters into the consideration is earnings growth. Your company may be making Rs. 1,000 today, but it may make Rs. 2,000 next year. For a 10% return, an investor might be willing to pay you around Rs. 15,000 for your company. He may only make 6.6% this year, but he makes 13.3% next year, and possibly more the year after.

So his Rs. 15,000 now can still be considered well invested as he would meet his investment objective. You can sell your company for Rs. 5,000 more. This is the reason why the shares of some companies are going through the roof even though they are not earning much money. Many people are projecting that their future earnings will be good, so they are willing to invest in these companies now.

What are stock markets? 

Stock markets are places where companies can offer their shares for sale. They do this through an Initial Public Offer or IPO. If a company sells 10 lacs of its shares at Rs. 10 each, then it is able to raise Rs. 1 Crore for itself.

Companies raise money for a variety of reasons. Mostly, it is to expand its business or to pay down debt.

Potential investors who look at a company's IPO will ask the same two questions outlined above. What is the company's earnings potential, and whether there are other investments which might give them a better return. If they decide that the company's earnings potential is good, and can offer a better rate of return, they will invest in it.

That is why many companies who offer IPO usually price their stocks at attractive levels.

After the IPO, the thousands or millions of investors who have bought the stocks can go back to the stock market and sell the stocks to other investors, so 'trading' of the stocks begin. A stock market is simply the clearing house for these 'trades'.

What causes volatility in stock prices?

Factors that affect a stock's price can be separated into 'macro' factors and 'micro' factors.

'Macro' factors are factors that affect the whole economy. Higher interest rates, inflation, national productivity levels, politics and such can have important effects on a company's earnings potential and so affect its share price.

'Micro' factors are factors that affect the company itself. Management change, prices and availability of raw materials, productivity of workers and such affect that individual company's earnings performance.

Fund managers and stock investors have to study both macro and micro reasons to try and ascertain the profitability of a company, and determine the 'fair price' of the shares.

What causes volatility in the prices is that there are often different opinions about where a company's earnings are headed. In a day when more people think that a company's earnings are headed down, there will be more sellers and prices will head down. Of course, the reverse happens as well.

Dividends

Price increase, or capital appreciation, is not the only way you can make money on stocks. Many companies also pay yearly dividends. These are cash payments that represent a portion of profits. However, it is entirely up to the companies whether to pay out dividends or not. They are not obligated to. But some companies have policies to pay regular dividends; they will return a portion of their earnings to reward their investors.

Diversify your risks 

While history shows that the prices of stocks of good companies will rise in the long run, there are no guarantees -- especially when it comes to individual stocks. Companies do go bankrupt. When that happens, the share price drops to zero (remember Enron?) and you lose all your money.

The best way to avoid this heartache is to diversify your investments by owning a variety of stocks. That way, the collapse of a single company wouldn't give you a minor stroke. You can either choose to hold a range of different stocks and monitor each one, or simply buy into an equity mutual fund, which is a diversified collection of stocks, and let a professional fund manager manage your money.

These fund managers spend all their time studying companies and their earnings potentials and chances are that they will do better at stock picking and make more money for you.

What you can be assured is that, there is definitely less stress, as you won't need to watch prices everyday!

Next : - Bonds