Stock Market Basics

Before you invest your hard earned money it’s a good idea to know some stock market basics. Basics of what, how, where and why you are investing. Although this is a vast topic, we will touch upon a few stock market basics that you must understand prior to investing any money.

Once you know the fundamentals, you can easily understand the intricacies and current developments without breaking your head. Although some parts my sound academic, we will use these as points of reference and focus more on practical aspects.

Techie meets Investment Guru

Mr.Venkat (or Venky as most of his close friends and folks call him) works for a top 3 software services firm in India and earns an excellent pay package as per domestic industry standards. Venky was not happy with the returns on his bank FDs, post office schemes, etc.

He chanced upon a meeting with an old friend Deva, who recommended that he invest in stocks, but Venky asked in a sceptical tone “Is it like betting in Las Vegas?” Venky didn’t even know stock market basics.

Deva strongly counters “No….you are wrong”

Venky: I know some of my friends who lost several thousand or even lakhs.

Deva: Trust me Venky – Risk is part of any investment but it can be controlled. There are good and bad elements everywhere. We can definitely meet up this weekend and I’ll tell you the truth and the risks involved and how it can be controlled.

Weekend Meeting

Venky and Deva meet once again and start their conversation.

Deva: Equities or stocks provide an opportunity to invest in a company and earn returns in the form of dividends or appreciation of capital.

Venky understood – but he was clueless. He wanted to get his stock market basics right, before investing any money.

Venky: Can you tell me what are stocks or equities? Although it sounds familiar it is quite alien to me.

Deva: Hey Venky – you asked a good question which most people hesitate to ask. Knowing this is an important step before you start investing.

This is how Deva explained some stock market basics.

Stock Market Basics – What is equity? What are stocks?

The term ‘equity’ generally means a stake or ownership interest in an entity. For example if A & B are owning a rice mill and have equal stake in the business, it means A has 50% equity and B has 50% equity in the business. This is a small business.

Large businesses will also require external funding or borrowings.

For example XYZ retail co has started its business with Rs.5 crore debt from GHI Bank, and another Rs.5 crore put in my the promoter. The total capital in this case is Rs.10 crore – of which 50% is debt and 50% is equity. Eg. If you hold 100 shares of Infosys you are a part owner of the company.

Your share of the share capital will be a small %age of the total stock of the company which can be several millions of shares worth billions of rupees.

Stock Market Basics – What is Debt? Debt vs. Equity?

In simple terms debt holders are lenders who lend money to a company, while equity holders are part-owners. Debt holders are entitled to regular interest payments irrespective of how the business performs, but equity holders get dividend only if the company makes profits (because they own the business and face the risk or rewards). In case the business does not do well debt holders will be paid first before settlement of equity holder claims. So equity holders can potentially lose their capital partially or fully.

Venky: So if I’m a debt holder I’m always at an advantage compared to equity or stock holder Right?

Deva: Not really. What I explained is only basic theory. In realty there are various factors that come in to play.

Generally speaking, debt holders are entitled to a fixed interest and principal repayment. They will not get any extra benefit or return if the business performance is excellent; however equity holders can get returns in proportion to the company’s earnings. This is similar to the fixed deposits that you are already familiar with.

But to decide what is good you need to look at several variables which will decide the return you get from both investment options. I will explain to you what you need to get started in investing.

Requirements to Start Investing in Stocks

To start investing in stocks by yourself you need to have the following:-

• A trading/investment account with a broker or financial services firm
• An online banking account (i.e. with net banking facility)

In some cases the trading account may be different from the demat account (where your stocks are held).

Venky: It sounds little complicated. Do I need to consult a Chartered Accountant for this?

Deva: Hey Venky, its just like your bank account man! Have you seen a bank statement or pass book?

Venky: Yes it shows all the transactions – withdrawals, deposits, charges, etc.

Deva: Your trading or investment account is almost similar. You will have a record of all your stock purchases and sales, charges, etc. You will also have a statement periodically sent to you.

Venky: Cool! But what about the share certificates, stamps and other paper work? I’ve seen my uncle do all that tedious work in the past.

Deva: Venky…..grow up buddy! You are still in the 90’s and 80’s. For the past few decades all stocks are transacted in electronic form (not physically). So you will find your stocks in a statement (just the same way your account balance is seen in your bank statement).

Venky: Is it? Cool! I didn’t know it can be so simple. Hey Deva, can you just briefly explain about the returns or earnings from stock markets. I head that people make millions in a matter of few months. Is it true?

Deva: I’ll explain this in detail, but remember this is not a ‘get rich quick’ scheme. You need a lot of patience to see solid returns. Equities or stocks are meant for long term investment only.

Returns from Stocks

There are broadly two ways that stockholders are rewarded:-

1. Dividend Earnings: This is just a small portion of the profits that the company pays to shareholders. E.g. if a company earns Rs.500 per share as profits, it might declare a dividend of Rs.100 per share.

2. Capital Appreciation: The price of a company’s share goes up overtime, which results in gains. When you sell at a higher price you make capital gains.

• Deva: Venky you remember Ashwin Parekh, the marwadi guy, who invested Rs.1 lakh several years ago in Infosys to see it grow to Rs.10 lakhs today.
• Venky: Yes man. He is a typical money-centric guy but he knows how to make money and build wealth.
• Deva: That’s the power of equities.

Stock Market Basics – What are Stock Exchanges?

Companies raise capital from public via stock exchanges. When a company comes to the public markets for the first time with an issue – it is called an “Initial Public Offering” or IPO. The market where IPOs are dealt with are known as “Primary Markets”.

On the other hand there are several companies such as ITC, HDFC, Infosys, etc which are already listed on Bombay Stock Exchange (BSE) or National Stock Exchange (NSE) or both. These listed companies are bought and sold in the stock exchanges or secondary markets.

Buying & Selling Shares

Venky: How do I buy or sell stocks on stock exchanges?

Deva: Simple. You can transact via your trading account, which in turn routes our transaction via the stock exchange.

Venky: How do I negotiate the prices or know the price?

Deva: Its all based on demand and supply, where there are multiple buyers and sellers for a given stock.

Venky: Oh I understand, but if I can see how it works it may be helpful.

Deva: Venky, I think you should visit the website of NSE and BSE. I will also help you open a trading/demat account. Once that is done we can sit sometime next week.

Venky: Thanks a lot Deva. You’ve actually opened my eyes. I’m looking forward to building a good set of investments in 2012 before I get tied up in another tedious software development and testing project.

Deva: That’s a wise decision. Have a nice day.

Then Venky decides that the year 2012 will be a good turning point for starting investments and to create a secondary income. Given the high uncertainties in the IT sector he also wanted to create some passive income to take care of his family needs.

Since Venky had humble beginnings and came from a middle class background, he was quite disciplined in terms of savings and financial management. However, he hardly managed to create wealth because he was only saving and putting money in FDs which fetched poor returns.

Now is the time for him to take some calculated risk to grow his wealth and move to the next level. Venky took his first giant leap in a few days which changed his life forever. So when are you going to take your first leap ?