Why your dad tells you to stay away from stocks
If you’re an Indian kid who’s ever discussed investments with their parents, then, it’s highly likely that your parents have kindly asked you to be wary of stock markets or they’ve sternly told you to avoid them all together.
While this is good advice, it isn’t the best advice.
Hold on. Let me make my case.
Two kinds of investors: Speculators and Value Investors
Let’s start with the definition of speculation.
A quick google search defines speculation as: the purchase of an asset with the hope that it will become more valuable in the near future.
Sounds quite like the definition of “investment”, doesn’t it?
You’re not wrong, but, the key differentiator between the two is the addition of the phrase, “near future”.
Those two words change everything.
Everything from your perception of markets, risks, and profits to the way you live your days.
Speculation involves making short term bets on companies, based on news and general opinion of the market. Most of the times, speculators completely disregard the company’s products, quality, competition, and financials; all things that really matter. Things that actually determine the future prospects of a company.
Example Time!
Recently, India’s Union Budget for 2021 was presented. And in this budget, it was mentioned that some of the public sector banks would be privatised. In other words, some of the government run banks like Bank of India, Bank of Maharashtra, etc. would be offered up to private investors.
Then came the news, a few weeks later, that out of four banks, Bank of Maharashtra, Bank of India, Indian Overseas Bank, and Central Bank of India, two would be chosen for privatisation.
As soon as this news hit the markets, the shares of these four banks shot up by 20%.
Why?
Did the privatisation happen? No.
Were the names of the two banks finalised for privatisation announced? No.
Were any buyers for these banks announced? No.
Is there any guarantee that these banks will do well after they’re taken over by private entities? No.
Then why did the share prices of these four banks go up?
You called it, speculation.
Most of the traders in any stock market are speculators. What these speculators thrive on, is, news.
What kind of news?
From time to time, the media reports mergers, acquisitions, product launches, etc. of companies. These are all events that don’t change anything for the company in the short term, but, do so in the long term. So, generally, to find out if such an event has impacted a company in a positive or negative manner, one has to wait for at least 6–8 months or even a few years. So, this is all super long term.
But, the speculators say otherwise.
When some news about a company comes out, the speculators get to work. They all want to make a quick buck, so they start making assumptions based on the sentiment the news would evoke in their fellow speculators. If the sentiment is positive, then, they start to buy up the shares. First, a few people do, the price goes up by a bit. Upon seeing this, a few more do, the price goes up again. Then this virtuous — or vicious — cycle starts to take shape, where, the higher the price goes, the greater amount of attention it garners, so on and so forth.
So, what’s happened here?
Seeing the price go up, the speculators, afraid of missing out on an opportunity to make some money, start buying the shares and consequently increase its price. Because the sheer number of speculators in any market is so high, this jump in price is quite extreme and takes very little time. We’re talking hours, or at most, days.
Everyone is aware that this is an unnatural rise and that it cannot be sustained. So, people start to get nervous. Because, they know that sooner than later everyone else is going to realise this, and would start to sell their shares to take home a profit, as well as, save themselves from the inevitable fall, the normalisation. Then, again, within a short period of time the stock comes plummeting down. If you were able to ride the wave just before it started going up and exited right before the price started to fall, then you make a handsome profit.
But, in reality, most people get on the wave after it has started to rise, and exit after it starts to fall. So what do they gain out of this?
Mediocre profits and a huge amount of stress, coupled with anxiety.
And if you didn’t watch the markets closely enough, and weren’t able to sell in time, you stand to lose a lot. Most of your profits, that you expected to make, could disappear and maybe even your principal.
*Cough* Gamestop *Cough*
When people look at the market from the viewpoint of a speculator, it all seems uncontrollable and without any pattern, consequently, making it appear overwhelming and confusing.
Value investing is quite the opposite
In this, you invest your money in a company because you believe, based on its track record, that the company will grow in the future — over a period spanning years — and that you want to be a part of that journey. Value investing is also based somewhat on news, but instead of reacting to it in the short term, you get in for the long haul, by putting your money in the company and showing that you support its objectives.
What this gives you, is two things:
One, it gives you peace and calm. Every time you see that the prices of your shares are either rising or falling unnaturally, it wouldn’t affect you as much. Because, you’ll know that it’s just the speculators having their way in the market, and that after a short time, the prices will normalise. This will only be possible if, at the start, you invested your money in the company because of the gains it can give you in the long run, not devoid of speculators, but, undeterred by them.
And two, good returns. Over a period of few years, generally, the market valuations of most strong companies — with good management, products, track record, and future plans — tend to double, or in some cases, even triple.
So which approach is smarter?
Speculating and making 10%-20% in a few months, or value investing in the same company and making 100%-200% in a few years?
There isn’t a right answer, but there is also a right answer.
Take a minute to process it.
So, coming back to why your parents tell you to keep away from stock markets
Most of the investors in any market are speculators. Chances are, your parents knew one, or, might have been one. And, as you know by now, speculation involves a huge amount of risk, mainly because people are betting on how the market will react to the news about a company, and not on how well the company will actually do. Despite of the speculators taking the share prices of a stock higher, over time, if a company doesn’t produce great results, the price of its shares will inevitably fall and the speculators won’t be able to anything. Speculation is nothing but blind betting. You’d be better off betting on a coin toss. And this is why your parents warn you about investing in stocks.
On the other hand, if your parents were value investors or knew somebody who was one, then they’d be aware of the fact that, value investing involves making disproportionately more educated bets. A decision on which you arrive at, after looking at the company’s track record, management, future prospects, products, and their competition. What this does, is it gives you more confidence in what you’re about to do, which is, become a shareholder of the company, adding your money to its war chest to help it cruise forward and grow. But with a little bit of a selfish motive.
If the fundamentals of why you choose to invest in a company are right, then, risk drastically reduces and the chance of making a good profit increases. This makes investing in stocks safe and appealing.
But, if it were so easy to be a value investor, then, why don’t more people practise it?
Because, most investors get into stocks for the wrong reasons. They look at the markets as an opportunity to make easy money. While there is no such thing as easy money, people still believe in it and also attach another connotation to it, that, easy money is always made quickly. And “easy money” stops looking so “easy” when you ask them to wait for longer to realise profits.
And because, they’re not willing to practise patience, speculation is the only way for them. Mediocre profits and high risks.
How to not be a speculator?
Speculation is tempting. The prospect of making a profit in a short period of time, who doesn’t want that?
But, via speculation, you also increase your chances losing an even greater amount of money in that same window.
And when you look at the big picture, you end up making just a fraction of the profits speculating, than you could have by value investing.
Every time, just before you’re about to buy shares of a company, ask yourself these questions. And based on the answers, you’ll be able to figure out if you’re getting into that investment as a speculator or value investor.
Q. Have you done your research on the company or have you just read a news article and made up your mind? If its’ the latter then you’re speculating.
Q. How long would you want to leave your money in these stocks? If it’s weeks, or months, then you’re speculating.
Q. Would you be fine if you didn’t check the prices of your stocks everyday? If not, you’re speculating.
Q. If your objectives are truly long term, then, would you be tempted to make a profit or save your self from a loss, seeing the speculators manipulate the price of your shares?
Q. Are you speculating?
Have you made your first investment yet?
If not, read the series of articles covering why you should invest to how you can get started.
Why does Let’s Talk Money exist?
To empower you.
Because, we understand the impact that the knowledge of a new tool or skill can have on somebody’s life.
And, financial literacy is one of those tools. It holds the potential, if harnessed, to change the entire course of a person’s life. Which is why we are working towards making the conversation around it more fun and engaging so that we can empower as many people as we can.
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