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Five wrong reasons to invest in equities
September 15, 2004 12:58 IST
Stock markets are once again the focus of attention for investors. And for various reasons. Some right and some, as can be expected, wrong. Here we take a look at some of the more popular but still 'wrong' reasons for investing in equities/equity funds.
1. FIIs and pension funds are likely to start investing in a big way
A lot of investors feel that with FIIs and pension funds (both foreign and domestic) increasing their allocations for India, the stock markets will rally.
This view has gained more popularity since CalPERS (a huge US pension fund) indicated that it would consider investing in India. More recently of course, there is a proposal to permit a part of the EPF monies to be parked in equities.
In our view, investments triggered on the basis of such developments will yield little for the long term investor. Theoretically put, the stock price of a company should equal its earnings per share (or its stock market value should be equal to its earnings).
But because the company is an ongoing concern, we tend to buy parts of the company (shares) at a 'multiple' of its earnings (the price to earnings multiple). And therefore, the market value of the company is several times its profits.
From a long-term perspective, earnings (or expected earnings) are the most important factor driving stock prices. Fund flows are more of a technical development which could impact prices for short periods of time (remember the swing between November 2003 and March 2004!).
2. There is no better avenue in present times
In our interactions with investors and, we are disappointed to say, with many experts, one reason for investing in equities/equity funds in current times is that there is no other equally lucrative investment opportunity.
So if you are 55 years of age and retired with limited savings should you redeem your monthly income plans (MIPs), et cetera and invest in equity funds? Or if you wish to invest for a tenure of 6 months, should you again go in for equity funds? In our view, No! (for both).
Before making any investment, ensure that it suits your risk profile and investment horizon. In the first case taken above, equity funds are the wrong choice as they carry high risk.
And since the pool of savings is limited, it is better to play it safe by investing in schemes including those offered by the post office or low risk debt funds. In the second case, equities/equity funds are ideally suited for a minimum investment horizon of three years.
The chance that you will make a return in a six month period is uncertain. On the contrary you could to lose a part of your capital.
Investment strategy for present times
3. Stocks tend to be relatively better performers in times of inflation
Inflation is an issue which we are faced with in current times. The solution for the otherwise cautious income fund/fixed deposit investor, of course, is equities/equity funds. Stocks it is said tend to perform better in times of inflation.
Take the case of a refining company in India which is not allowed to freely set the price of its produce (diesel for example). In current times part of the inflation is due to a sustained rise in global crude oil prices. Crude oil is a raw material for the refiner.
So even as the cost of the raw material is rising, the refiner is not allowed to fully offset this rise with a rise in the price of diesel. Its profits suffer and consequently its market value.
The point is that the view that stocks tend to perform better in times of inflation is general in nature. You need to evaluate each company/sector to determine how they are placed and accordingly take a call. In any case we recommend that if your risk profile does not suit equities/equity funds, avoid them.
Consider short term deposits which will ensure that you get the benefit of a rise in interest rates sooner than you would have in case you were locked into long term deposits.
Where to invest in times of inflation?
4. Because in the long run stocks give a better return
A seemingly convincing argument is that stocks tend to give a better return in the long term. At the start of the 1990s, the Dow was at 2,750. Currently it is hovering around 10,000 points. The BSE Sensex of course was 750 in 1990. Currently, it is at about 5,400. These numbers tend to underscore the view.
Although we are not in disagreement with this view, we do not support the implicit certainty that 'in the long run' equities/equity funds will outperform all asset classes.
One classic example is that there have been very long periods in history when the stock markets have not generated returns. For example, in 1929 and 1955, the Dow Jones Industrial Average was at the same level!
In fact returns would depend on among other factors the fund/company you have chosen to invest in and the timing of your investment.
So if you invested in Zee Tele at Rs 1,500 in March 2000 (current price is about Rs 150) or in a technology fund at the peak of the TMT bull market, you will have to wait for a long time to earn a return.
The Personalfn Real Return Calculator
5. Your broker / friend told you so
This is the most common 'wrong' reason for investing in equities/equity funds. You have a friend who has a friend and so on, who has 'information' about a company.
Or your broker / agent has given you a 'tip', which is likely to give you very high returns in a short period of time (interestingly there are few long term 'tips' doing the rounds!).
You, the retail investor, should take responsibility for your investment decisions. Before you make a commitment to a company or equity fund do your homework. At the end of the day, the broker/agent will make his money (he earns a commission) irrespective of whether you make money or not.
Undeniably, some brokers have your best interest at heart. But even then ensure his 'tip' is well substantiated.