Investing in Shares

While investing in shares, one is never going to be right or wrong. The object is not to be right all the time but to make money when you are right.

Illustration by Sahaj Tamrakar

We often hear that NEPSE has fallen by this point or rose by this points in a particular day. But what is NEPSE? I have often seen people confused with NEPSE and stock market, which is quite natural. NEPSE is simply the secondary market where shares of pubic listed companies are traded. The primary market is where companies float shares to the general public in an initial public offering (IPO) to raise capital. Therefore, if you want to invest in shares, ideally you have only two options i.e. i) buy shares from IPO, and ii) buy from the secondary market which is NEPSE.

Investing in stocks/ shares of various companies is not only interesting and exciting but also risky as well. People often forget that investment in shares is considered to be more risky than investing in corporate and treasury bonds. It is natural that no one likes to lose money. Moreover, the pain threshold of some is greater than it is with others. If we are considering an investment in the stock market and the thought of a loss upsets us, we probably shouldn’t invest. However, when we invest there are several things we should know to increase our chances of winning. The purpose of this article is not to give insight of fundamental and technical analysis of the stocks or how stock prices are affected due to investors’ behavior. It simply attempts to give some basic ideas of stock market behavior and investors, which are important factors that we need to know before we decide to invest in the stock market.

How investors gain or lose?

William Feather once said: One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute (smart).

Just like buying and selling any other commodities, there has to be two parties in the stock trading i.e. buyer and sellers. The fundamental questions of investing in the stock market however, is; how some investors gain while some other lose by buying and selling the same stock? For example, lets’ assume that the stock price of company A is Rs. 1200. Mr. Ram who owns a stock of company may think that this is the right price to sell therefore he asks his broker to sell it. Let’s assume that Mr. Shyam thinks that Rs. 1200 is the right price to buy. If we carefully analyze the situation, it is the same stock but one person thinks that it is the right price to sell while another one thinks that it is the right price to buy. Now the question is; who is correct? This is the most interesting issue of stock trading. If we can solve it, we will make millions. But unfortunately, it is not that simple.

It is important to note that stock market is a collection of millions of investors with diametrically opposing views. This is because when one investor sells a particular stock, someone else must be willing to buy it. Since both investors cannot be correct, it is an adversarial system. In short, one investor will profit and the other will suffer loss. How to ensure that we are correct? There is no definite answer to this question. But there are different ways that may help us to decide which stock we want to buy or sell.

 

If we are considering an investment in the stock market and the thought of a loss upsets us, we probably shouldn’t invest.

 

The first and foremost important concept of trading shares is to consider opportunity cost of investment. We should never make investment decision based on yes or no question. It should always be made based on either or questions. Let look at this with previous example. Suppose Mr. Shyam wants to buy share of Company A @ 1200. But what about buying shares of company B or C instead of company A? There may be chances that Mr. Shyam earns more from buying company B or C shares than company A shares. Mr. Shyam must carefully evaluate the option of buying company B and /or company C shares before taking decision to buy shares of company A. Similarly, let’s assume that Mr. Ram owns shares of different companies. He therefore, must evaluate/ consider selling shares of other companies before taking decision to sell shares of company A. This is called opportunity cost in the investment. Therefore, before we buy/sell any shares, make sure to analyze the best alternatives and become well versed on the investment we are considering.

Types of investors

In general there are two types of investors i.e. Speculator and General Investors. Speculators frequently buy and sell of stock within a very short period of time in attempts to gain from anticipated change in prices of the share. Speculators aim primarily at quick profit from a short-term acquisition of assets. Lets revisit the previous example. Mr. Shyam buys stocks of company A @ 1200. As per his own calculation and prediction, the stock price of company may rise to Rs. 1400 to 1500 within a month. Let’s assume that stock price of company A touched Rs. 1400 within a month as expected by Mr. Shyam. He now sells the stock and makes Rs. 200 capital gain (ignoring capital gain tax and brokerage commission). Mr. Shyam is a perfect example of speculator whose main objective is to gain from short term price fluctuation. But there is no guarantee that companies price always rise as expected or predicted by speculators. It may fall and they will incur loss. As a result, Speculator takes higher than average risk in return for a higher-than-average profit potential. Nepali stock market is largely dominated by speculators.

On the other hand, general investors do not care about short term price /market fluctuation. They invest for mid to long term; generally five to fifteen years and they generally follow buy and hold strategy. As a result, general investors do not take as high risk as speculators do.

Therefore, we need to decide who are we in terms of stock trading i.e. do we want to buy and sell quickly based on short term / price market fluctuation? Or do we want to invest for mid to long term? This is the first fundamental question we need to answer before we start investing in stock. If we are not aware of stock market movements and its functions, it is always advisable not to trade like speculators. It is a very risky venture.

What determines Stock Prices?

There are many factors that determine whether stock prices rise or fall. These include company’s performance like net profit, P/E ratio, and other fundamentals, the media, the opinions of well-known investors, natural disasters, political and social unrest, risk, supply and demand etc. The compilation of these factors, plus all relevant information that has been disseminated, creates a certain type of sentiment (i.e. bullish and bearish) and a corresponding number of buyers and sellers. If there are more sellers than buyers, stock prices will tend to fall. Conversely, when there are more buyers than sellers, stock prices tend to rise. Stock market is considered as a Bull, when prices of securities are rising, people are optimistic about stock trading and confidence levels of investors are high. As a result, market indices like the NEPSE go up too. During this period, demand of shares traded increases and hence; the prices of the shares also start to rise. A Bear market is the opposite to a Bull. A Bear market is a situation when investors showing a lack of confidence. Prices hover at the same price then go down, indices fall too and volumes are stagnant.

 

If there are more sellers than buyers, stock prices will tend to fall. Conversely, when there are more buyers than sellers, stock prices tend to rise.

 

As a rule of thumb, we need to understand the general market conditions before trading shares. There may be some shares which is good buy / sell during the bull market situation and at the same time, there may be some stocks which are good buy/sell during the bear market. Therefore, try to get fair understanding of the general market condition before taking buying and selling decision. This process is also known as Market Timing. Market Timing is extremely difficult process and needs lots of expertise and experience. If necessary, get some advice from professional portfolio managers.

Can we predict the stock price?

Unfortunately for all of us, the stock market is unpredictable and uncontrollable. That’s exactly why it can be so frustrating for so many people. Please remember that the stock market just like everything else, runs on cycles. What goes up comes down and what goes down comes up. What goes up the most can come down the most and vice versa. After every bear comes a bull. After every bull comes a bear. This essentially means that if stock price is rising since several years there may be chances it will start falling soon and vice versa.

Let’s assume stock prices have been rising for several years. Investors realize that the time has come that the stock prices will tumble. What we don’t understand is what will trigger the selloff or exactly when it will occur. Therefore, some investors will sit on the sidelines holding cash, waiting for the opportune time to get in. Those who are willing to assume the risk may jump in because the return on cash is so low and it hurts to earn zero while watching stocks move higher. This begs a couple of key questions. If you’re on the sidelines, how will you know when to get in? If you’re already in, how will you know when it’s time to get out? If the stock market was predictable, these questions could easily be answered. However, it is not. In finance text books, several methods are provided to predict stock price including technical and fundamental analysis. But there is no such thing as perfection when it comes to investing and predicting stock prices.

Conclusion

In investing, we are not going to be right every time. We are not going to always be able to buy low and sell high. But remember, the object is not to be right all the time but to make money when we are right. Therefore, the first step of any investment is to make our plan rather than blindly following someone else. To prepare plan, we must have fair understanding of the market, its participations and basic of stock. Therefore, second step is to understand the basics of investment including the market. Third step is to stay in the course and don’t panic with the short term market fluctuations. That means sticking to our plan, investing in good-quality, profitable companies and selling losers sooner rather than later.