Equity investing is all about a risk-return trade-off. When you have a longer-term perspective, you buy higher returns by taking on higher risk. Equity shares as an asset class entail higher risk compared to bonds or liquid funds. But in the long-term, they do give higher returns with substantially lower risk levels. In the long run, the biggest risk is not taking on any risk and that is why equities are a must in any long-term portfolio. Let us look at the risks and rewards of investing in equity to understand this trade-off.
Rewards of investing in equity shares
You would have heard of how stock like Wipro and Eicher created tremendous amounts of wealth for its investors over longer periods of time. Just to take an example, an amount of Rs.10,000 invested in Wipro in 1980 would be worth Rs.600 crore today. This is not considering the Rs.1 crore in annual dividends that you will continue to receive. Even the Sensex has outperformed other asset classes over the last 35 years. Here is what you need to know about the rewards of equity investing.
- The only way to long-term wealth creation is via equities. Since the value of the equity share grows along with the growth in the business of a company, the returns tend to get compounded over time. That is why, when you hold on to equities for a longer period of time, the power of compounding works immensely in your favour. Over a period of 8-10 years, equities can give strong positive returns with almost negligible probability of negative returns. Of course, a lot will depend on the quality of portfolio selected by you.
- As an equity investor, you get share of company ownership. This means two things. Firstly, you are part owner of the company and that gives you the advantage of owning a growing asset. Secondly, as a shareholder, you are entitled to vote in the AGM of the company and you can express your views on critical company decisions that are discussed in the AGM.
- Regular dividends are a source of income for investors. Many investors put their money in equities for the regular dividend payments. That is where you look for attractive dividend yields; which is the rupee dividend yields divided by the market price of the stock. If a stock quoting at Rs.100 pays Rs.4 as dividends then the dividend yield is 4%. This normally works as a support for the stock price.
- As a shareholder, you also are entitled to corporate actions like rights, bonuses and splits. Bonus and splits do not change your wealth equation because the increase in number of shares is offset by the fall in price. But it has a sentimental impact. When a stock trading at Rs.2000 comes with a 10:1 stock split, it starts trading at around Rs.200 and that makes it a lot more affordable to investors. This builds up the demand for the stock and is price accretive. In case of rights, there is a genuine benefit because rights are mostly issued to existing shareholders at a discount to the market price. This is actually value accretive for shareholders.
Risks of investing in equity shares
Just as there are rewards from investing in equities, there are also the concomitant risks. For example, there are no guaranteed returns of capital or regular payments. To that extent, equity shares are riskier than other asset classes. Here are 3 risks you need to know about.
- The first risk is the capital risk. To take a very straight example; had you invested in shares like Kingfisher, Deccan Chronicle, Satyam or Gitanjali Gems you can as well bid your money goodbye. We have seen violent corrections in stocks like Vakrangee, Manpasand, PC Jewellers, and Dewan Housing etc. You actually risk losing your entire capital if you don’t do proper homework and don’t manage your risk properly.
- Then there is the volatility risk. Volatility is negatively related to valuations. Normally, stocks with high levels of price volatility tend to get lower valuations in the market. That is one of the reasons why an ICICI Bank always gets lower valuations compared to HDFC Bank or Kotak Bank. This is the second major risk that you run. This volatility is caused by macro factors like inflation, interest rates; or by company-specific factors like performance, margins etc.
- Finally, there are the unsystematic risk factors like company performance, product obsolescence, disruption etc which can really impact the performance of these stocks. They add to the risk of a stock and impact the price.
Investing in equity shares is a constant risk-return trade-off. Apart from the fundamental factors, the timing of the entry also matters a lot. The best of stocks can be good at a certain price and overvalued at another price. That is something you need to work around.
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