At a time when returns from debt products and gold have fallen, investors are looking at equities for higher returns. Individual investors have started understanding market volatility and are buying stocks at dips. Investing in stocks directly requires a lot of discipline, knowledge about sectors and macro economy and, sometimes, a bit of luck! As the movement of the stock market indices is never linear, one should buy at dips and sell when the stock rallies. Unlike fixed income instruments like bank deposits, stock market investment entails some risk. But the risk can be minimised with some calculated steps. Here are some risk factors one must keep in mind before investing in stocks.
Understand the firm and invest
If one makes an investment based on messages from brokers or expert opinion on media, it can only make the magnitude of risk higher. Always invest in a company which you understand well. Look at the company’s financial performance, track record, business costs, leadership, risk factors, dividend history and corporate governance before investing your money. In fact, always remember that the way a company’s management functions and the way it manages its money flow will show how its stock gets priced in the stock market. So, before you decide on investing in any company find out if the company has created value for its shareholders and shared the profits with them. Find out if the company is investing its spare cash properly for its future expansion and find out if the balance sheet has sufficient strength to be able to cover short-term debts or liabilities. If you are convinced of these factors, your risk will be mitigated by a large extent. Properly managed companies will show consistent returns. Strong corporate governance will determine the stability of the organisation and will make it a better buy.
One must understand that greater risks may not always translate into higher rewards. It is necessary to understand what kind of risk you are willing to take and how to refrain from unacceptable risks. Look at the earnings growth of the particular stock and the fundamentals before investing. A 15-20% return on equity investment will be attractive if other asset classes such as gold and real estate are not doing too well. Analysts suggest looking at a stock’s price-to-earnings (PE) ratio to calculate the risk-reward. If the stock has a PE that is lower than its growth rate, then it would be cheap and good to buy. On the other hand, if the PE of a particular stock is twice the size of its growth rate, then it is expensive and should ideally be sold. In fact, such stocks are most perceptible to drop in price and are not at all good investment options.
A stock can become overvalued if there is a surge in demand, mainly driven by investors’ anticipations. However, if the increase in the stock’s price does not justify the company’s financial status, cash flow and order book pipeline, then the stock is overvalued and one should not consider such stocks. Typically, an overvalued stock reports a price slump and returns to a level where it reflects its financial fundamentals and status correctly. Overvalued stocks are not counted as good buys and should be avoided while making investments.
Steep jump in prices
If the indices or share prices are touching life-time highs, it is better to stop investing for some time till the market corrects. Preserve your cash to utilise it when the stocks prices correct. In fact, enhancing your cash balance can act as a hedge to take advantage of the movement of the market in either side. If the market goes up, you are staying invested and if there is a correction, you have the cash to buy shares at cheap rate. Institutional investors and mutual funds generally park significant amount of their money in blue-chip stocks, which have high market capitalisation and are most liquid. A share with higher liquidity implies that at any point of time there are adequate number of buyers and sellers. Blue-chip stocks are less volatile than other stocks and are preferred by conservative investors.