Q&A: Introduction to Investing in Stocks

I am an Engineering graduate and recently took up my first job. I am new to investing in stocks but eager to make a beginning. Can you explain to me what exactly is a ‘stock’? Why we must invest in stocks? How can I start investing in stocks? - Reader

The most common misconception among new investors or people who are averse to investing in stocks is that stocks are simply pieces of paper to be traded (albeit electronically these days). Some even equate it to gambling. The truth is that although there are many speculators in the stock market hoping to make a quick buck, stock investment is different from speculation. In stock investing, trading is a means, not an end.

A stock is an ownership interest in a business. When a person or small group of people starts a business, how much of the business each founder owns is a function of how much money each invested. At this point, the company is considered “private”. Once the business reaches a certain size, the company may decide to "go public" through an IPO (Initial Public Offering) and sell a chunk of itself to the investing public. This is how a company gets listed in the stock exchange and stocks are created.

When you buy a stock, you become a fractional owner of the business. Over the long term, the value of that ownership stake will rise and fall according to the success of the underlying business. The better the business does, the more profits the company makes, and the more your ownership stake will be worth.

Once a company gets listed through an IPO, anyone can buy/sell the company’s stock and checkout the price of the stock in the stock market. The price of the stock at any point is nothing but the most recent price at which the stock changed hands from seller to buyer. In India, two prominent stock exchanges where companies get listed and their stocks traded are BSE (Bombay Stock Exchange) and NSE (National Stock Exchange). Both are electronic exchanges with computers doing the matching of buyer and seller. You can buy/sell a stock listed in any of these exchanges, only through stock broking companies who are registered members of the exchange.

So, the first thing you need to do to start investing in stocks is open an account with a stock broking firm. You can open a trading account with the broking arms of banks e.g. SBI capital securities, HDFC securities, ICICI securities or standalone stock broking firms such as IndiaInfoline or ShareKhan. The good news is that most stock broking firms provide you with online trading facility. This means you can buy/ sell at the click of a button and monitor your portfolio value on a minute-by-minute basis (although the latter is neither advisable nor necessary for being a successful investor). The second thing you need to do is open a demat account. These days, stocks are no longer available as pieces of paper - they are digital or in other words dematerialized. Your demat account is like an electronic locker where your digitized stocks are stored. You can choose to open your demat account with a bank or with your stock broking firm.

Reasons to invest in stocks

We all have financial goals in life: to pay for college for our children, to be able to retire by a reasonable age, to buy the things we want. Unfortunately, spending less than we earn is typically not enough for us to reach our goals. Thankfully there is help at hand – by merely investing our savings we can make it grow in value and generate returns. Stocks are just one of many possible ways to invest our hard-earned money. So why choose stocks instead of other options, such as fixed deposit, bonds or gold coins? This is because stocks are quite simply one of the best ways to make your investment work the hardest – they provide the highest potential returns over the long term. This is particularly important because even 1% extra return per annum over the long term can translate into windfall profit, thanks to the power of compounding.

On the downside, stocks tend to be the most volatile investments. Meaning their prices can vary wildly – both over short term and long term. There's also no guarantee you will actually realize any sort of positive return. So it’s important to know what you are doing and resist the temptation of buying a stock because you received a ‘hot tip’ (a sure-fire way to lose money).

The best part is - Investing in stocks is not rocket science and can be self-taught by reading good books and company annual reports. Books on Warren Buffett are a must read. Some other great investors whose books you can read are Benjamin Graham, Philip Fisher and Peter Lynch. As a beginner, I suggest you start with ‘Learn to Earn: A beginners guide to the Basics of Investing and Business’ by Peter Lynch. The only real characteristics shared among successful stock investors are basic math skills, a critical eye, patience, and discipline. Combine these with an understanding of how businesses satisfy customers, compete with one another, and make money in the process, and you have all the mental tools you need to get started. A primer on accounting would also help.

You may think all this sounds like a lot of effort, but it can bear many fruits – not only in the form of higher returns but also by helping you understand how the world works. Moreover, learning to invest is something that you can do at your own pace, as a hobby, for the rest of your life. After all investing is an art, not a science. Even the world’s greatest investors, continue to build on their knowledge and fine tune their skills by spending most of their time reading (and very little time on actually buying/selling).