Equity shares are the most common way people invest in the stock market. Many people invest in equity shares in hopes of earning higher returns than stocks have historically offered.
For example, in the decade between 2011-2020, India’s benchmark index, the Nifty 50 Index, delivered a compound annual growth rate of 8.81%. In simple words, if an investor had invested INR 5,000 in Nifty 50 in 2011, the investment would have been worth INR 11,630 in 2020.
For the same period, the BSE Sensex index gave a compound annual growth rate of 11.12%. That means if an investor had invested INR 5,000 in BSE Sensex in 2011, the investment would have been worth INR 14,350 in 2020.
What is a share?
A share is a partial ownership in a company. When a company is formed, the initial capital requirement is met by the partners or investors who own the company. As a company grows, its capital requirements increase. A company can raise capital in various ways such as business loans, adding partners, approaching new investors and others.
The most common and preferred way to raise business capital is to issue shares, a process known as going public or launching an initial public offering (IPO). These shares are issued to investors with the option of trading on stock exchanges such as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
Being a shareholder also gives the investor the right to participate in the profits and growth of the company. A company issuing shares ensures that profits are shared with all shareholders in the form of dividends.
Every company specifies the rights and responsibilities of shareholders through two documents – Articles of Association (AoA) and Memorandum of Association (MoA). These documents include details such as the company’s business objectives and rules regarding distribution of dividends to shareholders.
Types of shareholding
Shares are mainly classified into two main types – preference and equity.
Preference shares
When a person holds preference shares, they have preferential rights to:
- Earn dividends at a fixed rate. When a company books profit and extends it to its shareholders, the amount distributed in this way is called dividend. It is usually calculated from net profit after deducting necessary expenses. The rate at which dividends will be paid is decided by the board of the company.
- Receive repayment of capital in case of liquidation of company. Winding up is the process of dissolution of a company. When a company goes into liquidation, it stops doing business and sells its assets to repay creditors, partners and shareholders.
Preference shareholders have limited voting rights compared to equity shareholders and can only vote on matters affecting their rights.
Equity shares
All shares which are not preference shares are equity shares and are also known as ordinary shares.
A person holding equity shares has the right to vote in company decisions.
As an equity shareholder, you are entitled to a claim on any profits made by the company in the form of dividends. It is important to note here that when a company books profit, its management has the right to decide whether:
- He wants to reinvest the money for business growth and/or expansion; Or
- Pay a portion of the profits to shareholders as dividends.
This is decided by the Board of Directors and the shareholders have no influence on this decision.
There are some companies which do not declare dividends. Also, if a company has declared dividends in the past, there can be no assurance that it will continue to do so in the future.
Advantages of Investing in Equity Shares
Investing in equity shares offers certain advantages. It includes:
High earning potential
When you invest in equity shares, you have double the earning potential:
- Increase in capital due to increase in share price.
Once a company issues shares, they are listed on a stock exchange to allow investors to trade in them. Based on the supply and demand of a particular share, its price may go up or down. If you buy a small amount of stock and the demand for it increases while the supply is limited, you have an opportunity to build wealth.
For example, suppose you buy a share of a pharmaceutical company at a market price of INR 100. A year later, demand for the company’s stock increases as most investors expect the pharmaceutical sector to grow and the stock price rises. INR 150. This gives you an opportunity to earn capital appreciation at the rate of 50% in one year.
- Regular income if the company declares dividend .
If the company decides to share the profits by declaring dividends, the shareholders have the right to claim it. If you invest in companies that declare dividends every year, it can add to your regular income.
Protection against inflation
A product worth INR 50 in 2010 will cost ten years more. As time passes, the value of money decreases and it costs us more to buy the same goods and services. This phenomenon is called inflation.
The current inflation rate in India is around four percent. This means a product worth INR 100 today will be worth INR 104 by the end of the year. Or, in 10 years, the cost of the product will increase by about 50%. So, you should invest your savings in such a way that it earns returns at a rate higher than the rate of inflation.
If you keep your funds in a savings account, you may not be able to beat inflation rates. Therefore, many investors opt for high-return financial instruments like equity shares to preserve the purchasing power of their money.
For example, between 2011 and 2020, bank fixed deposit rates have varied between six and nine percent. On the other hand, if we look at the compounded annual returns of market indices like Nifty, stock investments have shown the potential to generate double digit returns. Bank Index which gave a compound annual return of around 13.44% and Nifty FMCG Index which gave a compound annual return of around 15.24%.
Hence, investing in shares gives you an opportunity to beat inflation rates and preserve the value of your savings.
Diversity throughout the property
In simple terms, investing means buying assets that have the potential to generate profit. The various investment options available can be categorized into asset classes such as equities, bonds, real estate, commodities. These asset classes are classified based on risk, tax treatment and estimated return potential.
Traditionally, most Indians invested in bank fixed deposits. It is a low risk investment option where investors get a fixed rate of return on their investment. However, when the central bank lowers interest rates, your investment returns may decrease. If you have invested all your money in fixed deposits, you may see a drop in returns.
Therefore, it is wise to invest in a mix of asset classes such that negative performance of one does not affect your overall returns. Even if the interest on fixed deposits goes down but the value of the shares you buy increases, you can make a reasonable return. This concept is called diversification. By spreading your investments across different asset classes, you reduce risk and generate relatively stable returns.
Risks of Investment in Equity Shares
When you invest in equity shares, you are not guaranteed positive returns. Historically the prices of many equity shares have increased over time as companies become successful and grow and investor demand increases, there is no guarantee that this will happen. You can lose all the money you have spent on equity shares.
Even if you don’t lose everything you invested, you may face a situation where, due to the company’s performance or the overall market price, the company’s shares do not return to the price you paid. As an investor, you take these risks in hopes of making more money and building wealth.
The most common risks associated with investing in equity shares are:
Capital loss
The market price of a share depends on its supply and demand. If most investors believe that a company will perform well in the future, they want to invest in it and try to buy its shares. This increases the demand and consequently, increases the market price of the stock. Having said that, the opposite is also possible.
If most investors believe that a particular company may suffer losses in the future or possibly go out of business, they will start selling its stock. Therefore, there will be more sellers than buyers in the market for this stock, resulting in supply exceeding demand and a fall in the market price of the stock. So investing in shares carries the risk of losing money instead of getting returns.
For example, suppose you buy 100 shares of ABC at INR 100 per share and invest a total of INR 10,000. A few months later, some policy changes announced by the government made investors feel positive about the future of the company. Hence, the demand for the shares increases and the price reaches INR 150. If you sell the shares at this stage, you will get a profit of INR 5000.
On the other hand, if the announcement of a policy change makes investors feel negative about the future of the company, demand may decrease resulting in the share price falling to INR 75. If you sell your shares, you will incur a loss of INR 2500. .
Therefore, when you invest in shares, there is a risk of capital loss in the investment.
instability
Volatility is the fluctuation in the market price of a stock over a given period of time. So, if the market price of a stock fluctuates between INR 100 and INR 200 in a day, it is said to be more volatile than a stock whose market price fluctuates between INR 140 and INR 160 in a day.
Since the market price of a share is determined by the general sentiment of investors about it and is influenced by a range of external factors such as social, political, macroeconomic, share prices can fluctuate over time.
When you decide to buy a stock, you want to buy when the price is low so that you can make a return even if the price rises slightly. However, if the stock price is highly volatile, you run the risk of buying the stock when the price is high, pushing the cost of your profits higher. The same is true for investors selling highly volatile stocks.
Although risk is inevitable in investing, there are steps you can take to reduce the risk you are taking. You can invest in mutual funds or exchange-traded funds (ETFs) that provide exposure to hundreds or thousands of stocks and bonds, reducing many of the risks described here. Although they are not a guarantee against loss, they greatly reduce the risk of losing money when you invest in a company’s equity shares.
How to buy equity shares?
To invest in the stock market, you need three essential accounts:
- Demat Account – To hold shares in your name.
- Trading Account – To place buy and sell orders you need a trading account with a stock broker registered with a stock exchange.
- Linked bank account
There are two ways to invest in stocks:
IPO-route
When a company launches its shares for the first time, it announces a public listing called an IPO. As an investor, you can apply for an IPO through your net banking account or bid for company shares through a stock exchange.
Purchase from stock market
Apart from the IPO, you can buy or sell stocks in the stock market during the year by following this process:
- Open a demat account and trading account with a linked bank account.
- Log in to your trading account.
- Select the shares you want to buy.
- Finalize the price at which you want to buy.
- After the transaction is confirmed, transfer the money and complete the transaction.
Bottom line
As an investor, it is important to look at equity shares as an asset class rather than an investment vehicle. Investing directly in shares requires detailed research of the company’s fundamentals and financials.
It also requires proper understanding of timing and financial markets. So before you go ahead, make sure you understand the basics and invest according to your investment profile.