How to benefit from Share Market? Pros and Cons of Investing in shares

March 10, 2020 | Ambika Ojha

Introduction

A few years back, It was my birthday when my father said, “I have purchased some shares for you and that’s your birthday gift this year.” Then, while I did know what shares were (given my ongoing graduate training in business), my knowledge was obviously limited. For instance, while I think I did know that shares were used to raise capital by firms, it did not excite me much as compared to the excitement of getting a new dress or a new pair of shoes as a birthday gift. Since I expected a gift either in cash or kind, I was rather disappointed to hear of this investment in shares. It did not bring me immediate benefits or the satisfaction of having a new dress or a new pair of shoes. I was told that there are going to be returned in the later years.

Currently, thanks to Buwa’s prudent and well-researched ‘gifts’ of a similar nature over the years, I have a reasonable portfolio of shares which provide me a steady stream of periodic earnings (as dividends, for instance). I can buy a host of things including the new pair of shoes and that occasional dress. Alongside periodic earnings, my shares have grown in terms of their worth, i.e., I have had capital gains which means the value of my shares has gone up. If required, given that my shares are also assets in demand, I can part with them. Intricacies, complexities and inherent risks in investing in shares notwithstanding, I highlight this personal experience to emphasize that if done well and with caution, investing in shares can be rewarding.

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Apart from the dividends, tangible benefits accrue in the form of capital gains, bonus shares, privileged access to right shares as well as reasonably liquid assets. Alongside the monetary and tangible gains, my sense is that prudent investments in shares may well be a tool of empowerment for us women. The returns that accrue empower us, women, to be economically active and contributing members in our families. On a lighter side of things, we can buy our choices of clothes, shoes, a captivating book and even our favorite shade of lipstick.

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For all the benefits associated with an investment in shares, there are several disadvantages, inherent risks, and uncertainties. While, if researched well, several risks can be reduced, others remain. In the upcoming section, the article highlights the benefits as well as risks and disadvantages of investing in shares.

Benefits

Dividend: Dividend is a sum of money paid out of profits by a company to its shareholders. Dividends could be cash or shares.

Capital gains: Capital gains arise when the value of a share appreciates from its purchase price. However, this gain is not realized until the share is sold.

Limited Liability: If the company goes into loss, the share of loss over and above the capital investment is not borne by the investor.

Exercise Control: By investing, the shareholder gets ownership in the company and thereby can exercise control which comes in the form of voting rights.

Right shares: Whenever companies require further capital for expansion, they tend to issue the right shares. By issuing such shares, ownership and control of existing shareholders are preserved. The existing investor has privileged access to subscribe or invest in the additionally available shares over new investors. Right shares are issued at a price lower than the current market price of the equity share. So, existing investors can take advantage. Alternatively, the existing investor can renounce their right in others’ favor.

Bonus shares: At times, companies decide to issue bonus shares to their shareholders (often in lieu of dividends). It is also a type of dividend. Bonus shares are issued without any additional costs to existing shareholders.

Liquidity: The shares have reasonable liquidity which means if required, investors can offload investments to part with the proceeds.

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Disadvantages

Uncertainty in dividends: The management of the company decides when and how much dividend should be distributed. If there is a loss, dividends will not come about. But even If there is a profit, the Board of Directors may propose to not distribute dividends and instead choose to reinvest.

Investment in shares have inherent risks: Equity share investment is a risky investment as compared to any other investment like debt. The money is invested based on the faith an investor has in the company. There is no collateral security attached to it.

Fluctuation in the market price: The market price of equity share depends on the market sentiment which instead is a function of the overall environment within which companies operate.

Limited control: Unless one owns a significant stake in a company, voting rights may not as such empower this investor to influence the workings.

Residual claim: An equity shareholder has a residual claim over both the assets and the income. Income available to equity shareholders is after the payment to all other parties like debenture holders and preferred stockholders.

As the article has argued elsewhere, several disadvantages, risks, and uncertainties associated with investing in shares can be minimized and hence returns boosted.

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How does one optimize the returns?

Investing successfully is not easy. Whether one reaps benefits from their investment depends on several things including many that are beyond the control of a typical investor. To reduce the controllable and avoidable risks, credible analysis prior to making the investments is a must. This analysis can be categorized as a Fundamental Analysis and Technical Analysis.

Fundamental Analysis:

We can define fundamental analysis as going over and reviewing the “fundamentals”. Here the fundamentals could include anything that is related to the economic performance of a company – Revenues and profit trends, market share (and the trends), the quality of management and the kind of economic activity. Fundamental factors can also be grouped as quantitative and qualitative factors.

Quantitative fundamentals are easily quantifiable, readily observable and measurable characteristics. The basic source of quantitative data are the financial reports through which we can measure, inter alia, revenue, profit, assets, and returns. Similarly, qualitative fundamentals are less-tangible and difficult to observe and learn about elements that affect a business. The quality of the governing board, key executives, technology adopted, brand name and line of economic activity impact the functioning significantly, but these cannot be easily understood.

It needs to be understood that both quantitative and qualitative factors cannot be ordered and ranked based on their importance and significance in impacting a firm. They are like our two legs both of which are required for us to walk. Fundamental analysis entails the analysis of both the quantitative and qualitative factors. While doing fundamental analysis, we can analyze dividend payout ratios, earnings per share, price-earnings ratios and many other quantitative factors. But, our analysis of a firm would be incomplete without understanding who manages the firm or elements like if they are going to grow in the future (much of such analysis can be whimsical actually given the information incompleteness).

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Another important dimension that fundamental analysis focusses on is what can be called understanding the intrinsic value of shares. The fundamental analysis focusses to explain a stock’s “real” value. This real value is called intrinsic value. Suppose ABC Company’s share is trading at Rs. 120. After studying the company and comparing its performance with other firms in the market (which have similar quantitative figures and qualitative features), we may feel that the share is worth Rs. 150. Here, the intrinsic value of the share is Rs. 150. This is important because an investor wants to buy shares that are trading below the estimated intrinsic value. The intrinsic value that is derived from fundamental analysis helps in knowing whether we should opt for a long position or a short position.

Technical Analysis:

Technical analysis is a method of evaluating securities by doing a statistical analysis of market activity, such as price and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but rather use charts and other tools to identify patterns that can be used as a basis for investment decisions. They use historical price and other data to find future price movements. Technical analysis is based on three assumptions. They are:

A) Market discounts everything: Based on Efficient Market Hypothesis, Technical analysis suggests that a stock’s price already reflects everything that has or could affect a company, including the fundamental factors. This removes the need to consider the factors separately before making an investment decision.

B) Price moves in trends: Technical analysts say that a stock price is more likely to continue a past trend than move erratically.

C) History tends to repeat itself: The repetitive nature of price movements is often attributed to market psychology, which tends to be predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze these emotions and subsequent market movements to understand trends.

Thus, technical analysis studies share by, inter alia, studying the trends of price movements. However, we should remember that technical analysis is effective only when the price trend is influenced by supply and demand forces. When other factors like mergers, dividend announcements, accounting scandals, policy changes are involved in a price movement, analyzing stocks using technical analysis may not be successful.

Also Read: Bull and Bear Market: How to invest wisely in each market?

Conclusion

To conclude, investing in shares may be rewarding and empowering; a win-win for both investors and firms. However, returns come with risks. Many of these risks can be minimized to reap greater returns or minimize losses. Firm fundamentals – quantitative and qualitative – need to be studied well and a study of the price trend can also be done. While an investor may not be insulated from so-called vagaries of the market, some analysis based on available facts and figures may potentially protect us and enhance the possibility of rewards.