Chapter 3: In this chapter on commonly asked questions about the stock market, we dispel some of the myths usually associated with investing. The chapter also talks about the quantum of returns one should expect and the time horizon investors should look at.
I have heard of people making a lot of money in the stock market in a very short time. Does that happen?
Yes, it does happen, but rarely. The truth is that these stories go around much more widely than ones where investors lose a lot of money in a very short time, because they are stories of success. Sometimes, traders get lucky betting on a stock, and they make windfall gains very quickly, but that is not the usual pattern in the stock market. For traders, quick gains and losses cancel each other out over time, as the law of probability catches up with them. We only hear the good bits, and not the bad bits, and therefore conclude that making money is easy. This is a misleading impression.
What kind of returns can I expect from stocks? And how do I calculate these returns?
Stocks generate returns in two ways for long-term investors. The primary way is through capital appreciation, as the value of the stock rises and the secondary way is through dividends paid out by the company. The sum of the two can be construed as the total return from any stock from which costs such as brokerage have to be deducted. For long-term holders (greater than one year) the tax applicable on profits is 10 percent and for less than that period it is 15 percent. For traders, returns are generally only from capital appreciation net of brokerage and securities transaction tax. Profits are taxed as income at the applicable tax bracket.
Returns from the stock market are not linear, unlike say bank Fixed Deposits. Some years are good and some are not, but over the long term one can have an expectation of 14-15 percent annualised return, in India, which is very good. Anything more can be seen as a bonus. It is best to keep expectations modest.
Is it right to do a straight comparison of returns from various asset classes? How do I compare property, gold and fixed income with stock returns?
The short answer is no. The stock market offers instant liquidity, with the exception of very small cap names in difficult market conditions. Mostly, retail investors can sell what they want any day, when they need money. This differentiates it from property where apartments cannot be sold as readily, at any price. It's a very important distinction. Even for bank fixed deposits, the invested amount cannot be withdrawn at any time. Premature withdrawals attract penalties. In debt funds, if one doesn't hold for 3 years, the tax treatment is not favourable. Tax rates also vary across asset classes and equity generally offers the best taxation in India, thus far. Also, returns in different asset classes are not predictable or linear. In an FD, one can be assured of a certain interest payment every year. In stocks, there is no such guarantee, as is the case with real estate or gold, where returns are market determined. Each asset class is thus unique.
I have heard that stocks give very good returns over the long term. How do you define long term?
Yes, the holding period matters a lot in eventual returns from the stock market, but the choice of stocks is also very important. A dud company held over many years is still likely to erode your wealth. But since good companies with strong earnings growth and return on equity end up multiplying through different market cycles, it pays to hold them over time without being in a rush to book profits or keep switching them for other stocks. Also, the power of compounding works greatly in the favour of long-term investors. With stocks, the longer the better. Long term is generally defined as anything above three years, but the ideal is to try and hold stocks over a period greater than 8-10 years. Patient investors are rewarded most handsomely.
Are you saying that some stocks may not do well even if you hold them for a long period?
Yes. Stocks which don't have a dominant market position in their industry can easily lose market share to aggressive competitors and their profit growth can be affected severely. Also, stocks which don't have a Return on Capital employed or ROCE that is greater than their cost of capital, usually don't end up creating wealth for shareholders. Some stocks are inherently cyclical, such as autos/metals, and they go through boom-bust phases which affect returns over multi-year phases. Therefore, a long holding period is no guarantee of good returns from stocks.
I often hear experts use the term risk-reward ratio. Sometimes they say it is favourable and sometimes not; what do they mean?All stocks carry risk. Nothing comes with a guarantee. This is the first thing to understand for any investor. When one buys a stock, it is usually with the expectation that the company is good and growing and therefore stands a good chance of generating positive returns in line with the growth of the business. But at any point, it is only an assessment and an expectation, never a contractual guarantee as is the case with a bank Fixed Deposit. It may work out or it may not. From here, comes the phrase risk-reward ratio. The upside potential from any stock is the reward, the downside is the risk and both are possible. At any point, an expert has to make a judgement call on whether the chances of success are higher or the risk of failure is. One presumably buys a stock when the perceived chances of success are higher and that is when an expert says the risk-reward is favourable for the investor. When they say it is not, it means they feel that the risks outweigh the chances of positive returns and therefore investors are better off staying away. But, do remember that these statements are highly subjective and experts are often wrong in their assessment.