Module 1, chapter 1: Returns from your investments must be at least a step ahead of inflation. Otherwise, you will lose money. And equities remain one of the best ways to beat inflation. In this chapter, we will see how equity investments can help you beat inflation and earn great profits.
In the world of finance, equity refers to ownership of an asset. For instance, imagine a company owns assets worth Rs 1 crore. To fund these purchases, the owner infused Rs 50 lakh of his own capital, while the company borrowed the remaining Rs 50 lakh from a bank. As a result, the owner’s equity is said to be Rs 50 lakh. When you purchase a share in the company’s equity, you effectively become a part-owner of that business.
Understanding Inflation and Ways to Defeat it
Inflation is a macroeconomic phenomenon of price increases that directly affects your finances and money. Not only does it limit your ability to spend, it also eats away your returns. In the current scenario, fixed income investment instruments like fixed deposits (FDs) are greatly affected by price increases because the rate of inflation can be at par or higher than the returns provided by such investments.
In other words, if your cost of living goes up by 7 percent and your investment gives you only 5 percent, then you are losing money. The story is similar with other fixed income instruments such as government bonds and savings accounts, all of which sometimes offer lower-than-inflation returns.
An investor should opt for investments that are able to beat the inflation rate.
As we will go on to show, equity investments remain one of the best ways to defeat inflation.
Equity as a Weapon Against Inflation
Over the past 30 years, the Sensex has grown at an annualised rate of about 15 percent. This is because earnings of companies have grown at about the same pace.
On the other hand, most FDs and other fixed income instruments offer returns of 4-6 percent.
So it seems like a no-brainer that equities are better than FDs, right? But wait. Equity investments should be done after considering factors like overall asset allocation, risk tolerance, and financial goals.
For instance, while equity may provide high returns over the long term, they may not be a suitable option for short-term goals because of market volatility.
The Advantages of Investing in Equity
Capital Gains and Dividend
Over the long term, a company’s share price reflects its profit growth. If profit rises, so does the stock price. The increase in share price is called capital gains. Not just that, companies reward shareholders through dividends, a share of the profits made by the company.
By buying a company’s shares, you get part-ownership. In other words, you become a shareholder in the company with a right to vote on some important decisions.
Unlike some of the other asset classes like gold and real estate, you can sell your equity holdings easily on the stock exchange platform.
Many companies offer bonus shares to their existing shareholders on special occasions. These are equity shares given to the shareholders free of cost.
Some companies split the face value of their stocks. For instance, a stock with a face value of Rs 10 could be split into 10 shares of face value Re 1 each, or into two shares of face value Rs 5 each. This practice reduces the share price, but the value of your total holdings remains unchanged as you would own more number of shares now. The stock split increases the liquidity of the shares, which is another advantage of equity investments.
How to Invest Safely in Equities
Now that we’ve discussed what inflation is and how equity investments can help you overcome it, it’s time to discuss investing safely in equities. Here’s how to go about it:
- Do enough research and analysis before diving into the stock market.
- Open a demat account and trading account for trading/investing.
- Regularly analyse the balance sheets and cashflow statements of companies you’ve invested in. Keep an eye on the profit and loss (P&L) accounts of all these companies.
- Make sure your portfolio is diversified with shares of companies from different sectors. Also, track your portfolio regularly and don’t put too much money in a single company.- Equities can be volatile in the short term. Therefore, make your buying and selling decisions carefully. If you don’t have time, the inclination or a sound understanding of finance, it makes sense to take help from a financial advisor.