Why invest in the Indian stock market ? Step By Step Guide

Chapter 1
Why invest in the stock market ?

Investment involves the art of intelligently allocating our funds across diverse asset categories such as equities, real estate, or other monetary instruments or holdings, with the goal of securing a consistent income in the future and benefiting from the appreciation in the value of these assets. While this may appear straightforward, investing necessitates a blend of various qualities including wise judgment, patience, practicality, and the ability to overcome cognitive biases, among others.

Veteran investors like Warren Buffett and Charlie Munger emphasize the concept of reasoning from fundamental principles, which entails breaking down intricate problems into smaller components to find effective solutions.

To gain a deeper understanding of investing, it is crucial to grasp the concept of inflation. Inflation, in simpler terms, refers to the increase in the prices of goods we consume. For instance, if a packet of chips cost Rs 10 last year and now costs Rs 12, this indicates a 20% increase in the cost of chips from the previous year to the current year. The primary objective of investing is to outpace the rate of inflation, allowing us to maintain our standard of living without compromise.

Let’s explore the distinction between investing, saving, and spending through an example. Imagine you have saved Rs 1 lakh from your earnings and are contemplating how to utilize it. You have three options:

  1. Spend the money on a fancy new motorcycle.
  2. Save the money by depositing it in a fixed deposit.
  3. Invest it in the stock market.

How will these choices pan out over the next 4 years?

Case 1: Opting for the motorcycle means that after 4 years of use, it will depreciate in value. Suppose the best offer you receive is Rs. 60,000, signifying a nearly 40% decline in value over 4 years.

Case 2: Saving the money in a bank account with a 4% interest rate would result in a balance of approximately Rs 1.16 lakh after 4 years.

Case 3: Choosing to invest, let’s assume the stock market surges by 50% in the next 4 years. Your initial investment of Rs 1 lakh would be worth Rs 1.5 lakh. While market predictions are uncertain, making informed estimates is possible.

In these scenarios, we witness how saving, spending, and investing play out. Next, we must consider how inflation affects your decision.

Assuming an annual inflation rate of 5%, everything you intend to purchase after 4 years will be approximately 20% more expensive. For instance, the motorcycle may now cost Rs 1.2 lakh, making it unaffordable if your money was simply in savings. However, had you invested wisely in the stock market, you would not only afford the motorcycle but also have an extra Rs 30,000 in your pocket.

Therefore, the key takeaways from this example are as follows:

  1. Spending money results in its diminishing value over time, though it provides immediate utility.
  2. Saving money allows it to grow in value, but it may not consistently outpace inflation. Thus, savings are suitable for planned near-future expenses and emergencies.
  3. Investing money judiciously increases the likelihood of its appreciation over time, helping you beat inflation in the long run and maintain your desired lifestyle.

To plan your expenses more effectively, it’s essential to consider the future value of money when invested wisely, years down the line. This fundamental difference distinguishes spending, saving, and investing.

Chapter 2
Why invest in the stock market?

Overview

When it comes to the decision of whether or not to engage in the world of equities, individuals hold diverse perspectives. Some steer clear of it, perceiving it as akin to gambling. Others, influenced by movies or their own encounters, assert that it is under the control of a select few.

On the contrary, those in favour of investing in stocks view it as an opportunity for quick financial gains. They observe stock prices fluctuating dramatically over days or weeks, sometimes by 5%, 10%, or even 20%. They believe there must be a method to decipher the forces behind these price movements and anticipate substantial profits in a shorter time frame compared to a year-long fixed deposit.

Then there’s the more sophisticated rationale: stocks consistently outperform other asset classes over extended periods. When you ask a financial advisor why you should consider stock investments, they often present the long-term performance chart of the Sensex. It was at 800 in 1990, rose to 4,000 in 2000, reached 20,000 in 2010, and soared to 50,000 in 2020. Impressive, isn’t it? This showcases the potential of equities. They seem to always ascend. Your advisor may say, “If you’re optimistic about the Indian economy, investing in stocks is the best way to bet on its success.”

However, let’s step back for a moment. Could you have predicted, with any degree of certainty, back in 1990, 2000, or 2010, that the Sensex would surge anywhere from 2.5 to 5 times in the following 10 years? Can you confidently assert today that the Sensex will reach a level between 1.25 lakh to 3 lakh in 2030?

There’s a simple mathematical explanation for this, requiring consideration of two key aspects.

Math 1: The Pandemic and the Restaurant

Imagine it’s December 2019, and your friend recently opened a thriving restaurant. He offers you a 5% stake in the business for Rs 5 crore. The restaurant generates daily revenue of Rs 5 lakh with a 50% profit margin, resulting in yearly revenue of Rs 18 crore and a profit of Rs 9 crore. You calculate the business’s valuation and find it to be Rs 100 crore based on its Rs 9 crore profit. You decide not to invest.

Fast forward to June 2020, and the pandemic hits, causing a downturn. Your friend now offers you a 20% stake for Rs 5 crore, valuing the business at Rs 25 crore. You consider the potential and accept the deal. A year later, the restaurant recovers, and it’s expected to make a reasonable profit this year.

The lesson here is that as long as a business stays afloat, it holds value. Prices can fluctuate, but there will always be interested buyers at the right price.

One crucial point to remember from this example is the price-to-earnings (PE) ratio. Initially, your friend demanded a PE ratio of slightly over 10 times (Rs 100 crore valuation for a Rs 9 crore profit). Six months later, this ratio dropped to as low as 2.5 times.

Math 2: India’s GDP

India is a rapidly growing economy and is expected to remain so for a considerable period. One key reason is its relatively low per-capita GDP compared to other nations, providing inherent cost advantages.

Assuming an average growth rate of 6% since 1990, with an additional 5% for inflation, results in an average nominal GDP growth rate of 11%. The question arises: if the economy grows at 11%, isn’t it reasonable to assume that well-managed companies can achieve revenue and profit growth slightly higher, say 15-16%?

This aligns with the historical growth of corporate profits over the past 30 years.

The Long-Term Outlook

In the short term, stock markets, including indices like the Sensex, experience fluctuations, but the earnings of the underlying companies tend to increase over time.

To predict where the Sensex might be in 2030, consider the current earnings per share, say Rs 2,100. Plug it into a Compounded Annual Growth Rate (CAGR) calculator with a 15% yearly growth assumption. This calculation yields Rs 8,500. Now, multiply this figure by a PE ratio between 12 and 30, which represents the price investors are willing to pay for Indian companies. Where might the Sensex land? Anywhere from 1 lakh to 2.5 lakh.

Chapter 3
The Significance of Compounding and Why It’s Crucial for Wealth Building

Compounding is often hailed as the eighth marvel of the world, with Albert Einstein recognizing it as the most potent force in the universe. It’s been reported that he said, “He who understands it, earns it. He who doesn’t, pays it.”

So, what exactly is compounding, and why is it essential to grasp its concept?

Let’s start by comprehending what we mean when we refer to compounding.

The concept of compounding stems from what we know as compound interest, a concept most of us encountered during our school days alongside simple interest.

The formula for simple interest is straightforward: i (Interest) = p (principal) x (return) x t (time). For instance, if you invest Rs 10,000 in a fixed deposit offering a 10% return for one year, your interest (i) would be 10,000 x 10/100 x 1 = Rs 1,000.

Now, when you earn 10% on your fixed deposit, you have two choices: withdraw that Rs 1,000 or let it become part of your investment. In the latter scenario, next year, you’ll either earn Rs 1,000 again if you withdrew your interest or Rs 1,100 (10% of the revised investment amount of Rs 11,000).

The aspect where you earn interest on your interest is known as compound interest. While it has a somewhat intricate formula, let’s set that aside, as we’ve grasped the concept: allowing your returns to accumulate and grow your money.

There are two crucial rules to remember about compounding.

The first rule is quite straightforward: compounding’s power intensifies over time. If you invest Rs 10,000 with a 10% return, you’d earn Rs 1,000. If you let this Rs 10,000 (and the compound interest it generates) remain invested, it could grow to approximately Rs 1.75 lakh in 30 years. The lesson here is to begin early. If you invest Rs 10,000 each month starting at age 25 and continue until age 60, you’d have invested Rs 42 lakh over 420 months. Assuming a 10% return, your investment would grow to around Rs 3.79 crore. On the other hand, if your friend started at age 35 and invested Rs 20,000 monthly to compensate for the delayed start, they’d have invested Rs 60 lakh in total. However, after 25 years, they would only have about Rs 2.65 crore. Starting late deprived your friend of the crucial compounding effect over the last 10 years.

The second rule involves the rate of compounding. Small variations in compounding rates can result in substantial differences in returns over the long term. Consider this: imagine your parents invested Rs 1 lakh in a house in the ’80s, and it grew to about Rs 1 crore in 40 years, representing an annualized growth rate of 12.2%. Impressive, right? A 100x increase in 40 years. However, what if that money had been invested in the Sensex at 15% instead of 12.2%? The difference made by that 3% increase over the long term would result in the amount being Rs 2.67 crore today!

So, in essence, commencing early, remaining invested, striving for higher returns, and letting compounding work its magic can pave the way to substantial wealth.

Now, you might wonder how compounding applies to stocks. When you hold a stock for an extended period, you inherently benefit from compounding. How does this work? When a company generates profits, say Rs 100 crore at year-end, it allocates a portion back to shareholders (e.g., Rs 20 crore) as dividends while reinvesting the remainder (e.g., Rs 80 crore) into its business. This reinvestment fuels the company’s future growth, a manifestation of compounding. As stock prices typically mirror earnings growth over the long term, this translates into higher returns for stocks.

Here’s an interesting titbit: when a company growing at 15% provides you with a dividend, should you be pleased? Not necessarily. If you reinvest the dividend in an option returning less than 15%, you’re worse off!

Lastly, there’s an important point to remember about compounding: predicting the future value of an amount over a lengthy period with high returns can be challenging. People, even those skilled in mathematics, tend to be conservative in their calculations. This means that even a stock portfolio returning 14% may not seem extraordinary in the short term but can yield significant wealth over 30 years. Achieving an 18% return can lead to riches, and if you can grow your capital at 24%, it’s akin to the math Ramesh Damani used in a YouTube video to project a staggering Rs 100 crore!

In essence, aspiring investors should be aware that consistently earning a 10% monthly return is a near impossibility. However, with sound investment principles and the power of compounding on your side, achieving wealth is a realistic goal.

Chapter 4
Investment Decisions: Understanding Returns and Expectations

When making investment decisions, people often have certain return expectations for their investments over a specific time frame. The general rule of thumb is that the riskier the investment, the higher the expected return.

To delve deeper into this concept, we must familiarize ourselves with two types of returns: absolute returns and annualized returns (also known as the Compounded Annualized Growth Rate, or CAGR).

Absolute returns represent the total gains from an investment, regardless of how long you hold it. For instance, if you purchased a share of Reliance Industries for Rs 1,000 three years ago and it’s now trading at Rs 2,500, your absolute return on the investment is 150%. However, absolute returns aren’t suitable for comparing different investment opportunities because the time frames, capital, and investment horizons vary between them. To make comparisons more meaningful, we turn to annualized returns.

Annualized returns measure the Return on Investment you receive per year, compounded, on your investment. Using the same example, if you bought a share of Reliance Industries for Rs 1,000 three years ago and it’s now trading at Rs 2,500, we can calculate the annualized return using the CAGR formula.

CAGR formula = ((End Value / Beginning Value) ^ (1/No. of years)) – 1

By applying this formula, we find that the CAGR for your investment is 35.72%, which is a commendable long-term return. It’s essential to note that this return won’t progress linearly over the holding period due to market fluctuations, including bull runs, consolidation phases, and bear markets. The stock may have surged from Rs 1,000 to Rs 2,450 in the first year and then slowly gained the remaining Rs 50 over the next two years. Predicting a stock’s behaviour based on market dynamics is challenging. The key is to remain invested over the long term and harness the benefits of compounding.

Now, the question arises: what constitutes a good return to anticipate? The answer depends on your risk tolerance and your ability to hold onto stocks during challenging market conditions. Historically, a return of 12-15% per annul, compounded over the long term, is considered quite favorable, as it grows significantly over time. However, achieving such returns consistently year after year is challenging and depends on market conditions.

For instance, if you invest Rs 1 lakh in a fund offering a 12% annual return and leave it untouched while reinvesting the returns in the fund, you could potentially accumulate a corpus of Rs 26.74 lakhs in 30 years, without making additional contributions. This showcases the power of compounding.

Warren Buffett, often regarded as one of the greatest investors of our era, has consistently generated a 20% return for Berkshire Hathaway shareholders since 1965. By surpassing the performance of the S&P 500 in the USA, he achieved an astounding 2,472,627% returns, compared to the index’s 15,019% returns during that period. Notably, Buffett accumulated 99% of his current wealth after the age of 52. This underscores the importance of staying invested and having a long-term perspective.

In conclusion, it’s crucial to focus on the sustainable long-term advantages of investment, as these benefits tend to compound over time. Return expectations may vary based on the risk level of the investment, but an annualized rate of return between 12-15% can be considered a strong benchmark for a good rate of return.

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