The world of stocks is a highly dynamic one. One has to be constantly on one's toes in order to keep abreast with the latest developments taking place. To a layperson, it can be intimidating, with stock prices constantly changing every second.

Of course, we have seen during the (in)famous market crashes that can happen when things do not go according to what the market expects. An example is May 17, 2004, when the erstwhile National Democratic Alliance government lost power at the Centre.

The market had expected the NDA to retain power, and when that did not happen, it tanked by a massive 565 points, falling in intra-day trade by over 800 points! When this kind of activity makes even the most experienced investors quiver; imagine what the common investor must feel like!

In this article, we attempt to simplify matters for the common investor, by explaining some important terms that every investor must be aware of, not just while investing in shares, but for any other investment.

Concepts of 'Risk' and 'Return'

Risk, in simple terms, can be defined as the possibility of the stock showing negative returns on an investment. While quantifying and calculating risk, we generally use a variable called as 'beta'.

This implies the volatility of the stock with reference to the benchmark index, generally taken as the BSE Sensex or the NSE Nifty. If the beta of the stock is 1, it means that the returns in the stock are highly correlated to the benchmark index.

Stocks in sectors that closely track economic growth like cement, infrastructure or oil and gas generally show this kind of beta. If the beta is higher than one, it means that the stock is more volatile than the index, and in a bull market, will generally outperform the index.

However, in times of a downturn, the fall in such a stock is generally more pronounced than that in the index. Examples are stocks in high-growth sectors like software, BPO, and pharma.

If the beta of a stock is less than one, it means that the stock is less volatile than the index, and the company operates in a sector that is relatively stable, without much volatility. An example of such a sector is FMCG.

E_R = RFR + 'beta' of the stock (M_R -- RFR),
where E_R = Expected returns,
RFR = Risk-free rate (generally taken as the yield on 10 year G-Secs), and
M_R = Market rate of return

Returns are correlated with risk. The lower the risk, lower the returns that can be expected. On the other hand, the higher the risk associated with the stock, the higher are the returns that can be generated, in order to compensate the investor for bearing such a high risk.

Software companies have a higher risk profile, thus, the returns they have generated over the years have been higher, as compared to low risk sectors such as FMCG.

Of course, investors need to note that this is a generalisation, and the specific performance of a company in its sector of operations may vary depending upon the performance of that company, the market perception, ability to survive in a downturn, future growth prospects, ability to corner that growth, and other such factors.

Investment horizon

Any investor, before making an investment decision, must be clear about the kind of time he/she is willing to give his/her money to grow.

The equity markets are home to all kinds of players -- short term 'punters', who invest based on technical analyses/tips, also known as 'speculators', arbitrageurs, who take advantage of the price differentials in different markets, and the long-term investors, who generally view the market over a long period of time, based on fundamentals.

Considering the high-risk nature of the equity markets, for retail investors, it is advisable to invest with a long-term horizon in mind. Equities as an asset class have outperformed other asset classes over a longer period of time.

They are the best possible hedge against inflation and in times of high inflation, are possibly the only assets that will give you a positive real rate of return after taking inflation into account.

Therefore, any investor must have a clear idea in his/her mind as to the time frame of the investment. Long term investing, taking into account fundamental growth stories, and strong future growth prospects have the potential to deliver solid returns on investment.

This is the best way to reduce risk. As the legendary investor Warren Buffet has said, 'Risk is not knowing what you are doing.' Studying the company/sector thoroughly before taking any decision is essential.

In case any investor does not want to enter the markets directly, he/she can always take the mutual fund route, and leave his/her money in the hands of experienced fund managers with good track records.

Asset allocation

In simple terms, this means spreading your investments across various instruments and asset classes, like equities, debt, bank deposits, mutual funds, post office savings, property, commodities, art and so on. This is a vital term that needs understanding.

It is always a wise decision to diversify your investments across various asset classes, so as to reduce the risk of a particular asset class giving low or negative returns.

Putting all your eggs in one basket is a risky strategy. A good mix of equity, debt, mutual funds and other asset classes provides safety as well as the possibility of generating high returns. In fact, even in each asset class, like equities for example, it is advisable to diversify and have a number of shares in different sectors in one's portfolio, so as to reduce dependence on just one stock or sector.

Similarly, for mutual funds, it is better to invest in schemes with a good track record, and from a variety of fund houses.

As far as the exact allocation to each asset class is concerned, it depends on person to person, the risk profile of the investor, and the time horizon of the investment.

Generally, younger investors who have started out early in their careers can afford to take higher risk and go for a greater proportion of equities and equity mutual funds in their portfolio, while those who are about to retire and thus, will not have any direct source of income, are better advised to have a high proportion of investments in safe instruments such as bank deposits, post office savings, and pension plans.

Conclusion

We have understood the basic terms that any investor needs to get clear in his/her mind before taking an investment decision.

Depending on the age, risk taking ability and time horizon, an investor should accordingly put his/her money in different asset classes in the proportion that suits their unique needs and requirements the best. Investing on the basis of rumours or speculation is a high-risk activity, and must be avoided as far as possible.

With the complexity and dynamism of the financial markets increasing with the passage of time, there is a massive information overload for all investors. Big investors like FIIs have the time and expertise to manage such risks.

But for a retail investor, this can be highly intimidating. It is best to ascertain one's own unique requirements based on the parameters discussed above, depending on which one can draw out an investment plan.

Discipline is the key to good investing. One must have patience, and give his/her money the time to grow. In the long term, this is a factor that often differentiates the winners from the losers in the game.