Over the years, stocks have become synonymous with investing. As a new investor, you might have heard many rags to riches stories of people making unrealistic returns by investing in stocks. But, will it work for you too? Is investing in stocks worth it? Worth the risk? Let’s look at both sides of the coin.
What are Stocks?
A stock, also known as equity is simply a share in the ownership of a company. When you buy a stock, you purchase a small part of the ownership. Being an owner, you get a share in the profits of the company but also need to bear the losses. However, your loss liability is limited to the paid up value of the share.
For some companies, the shares are not available in the market. These are owned by a handful of people. These companies are private companies. On the other hand, public companies or listed companies have their shares traded on stock exchanges.
Stocks can help you make money in many ways. Whenever a company makes profits, it shares the profits with its shareholders in the form of dividends. Also, the market demand and supply of a share determines the price at which it is traded. This gives investors an opportunity to earn returns if the demand of the stocks that they have purchased increases.
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Having understood stocks, let’s look at the pros and cons of investing in stocks:
Pros of investing in stocks
From an investment perspective, stocks offer the following advantages:
- The Growth of Capital – If you look at the performance of stock prices, over a period of time, the prices tend to rise. Therefore, if you invest in a basket of shares, then on an average, you can expect your capital to grow over time.
- A better chance of earning good returns – As compared to investing in deposits or bonds, stocks offer a better possibility of generating good returns. Since the equity market is volatile, there is no guarantee of the amount by which it will rise or fall. This gives investors a chance to earn excellent returns if the market moves in a favorable direction.
- Some hedge against inflation – Think about it. If the inflation rates increase, the prices of products increase and companies book more profits (especially if they are well-prepared). As a shareholder of such company, you can expect better dividends. Also, if a company is declaring good dividends, chances are, that its demand increases which help you fetch a better price. Therefore, while not direct, investing in stocks helps hedge against inflation up to a certain extent.
- Mutual Funds allow you to invest in a basket of stocks for a combined benefit – Many investors find investing in individual stocks risky, since it is impossible to predict the performance of a company or the demand for its shares, Mutual Funds offer a great option. You can invest in a Mutual Fund scheme which allocates its funds across specific market segments and benefits from the expertise of the fund manager.
Cons of investing in stocks
Here is a quick look at some of the disadvantages of investing in stocks:
- Let’s say that you invest in a company’s shares which becomes bankrupt after a few months. In such cases, the value of the shares of the company will become zero and you can lose your invested amount.
- A simple way to earn money in the stock market is to buy a stock when its price is low and sell it at a higher price. However, this requires you to hold on to your investment until you get the price that earns you good returns. In case of urgent need of funds, you might have to sell the stocks at a price lower than your purchase price.
- Trading in stocks involves certain charges and fees which can eat away at your returns. Therefore, you must factor in these costs before buying/selling stocks.
- In the stock market, it is impossible to predict returns. Therefore, as an investor, you cannot plan your finances in advance.
Before you start evaluating the pros and cons, there is an important aspect about investing in stocks that must keep in mind – diversification.
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What is diversification and how it helps in investing in stocks?
Diversification, in simple terms, means ensuring that you do not put all your eggs in one basket. When you invest in stocks, it is important to spread your investments across shares of multiple companies from different sectors. Therefore, even if one sector performs below expectations, some other sector would pick up and your investment portfolio will generate profits (or at least curb losses).
If you do not have the time or inclination to create a diversified investment plan, then you can employ the services of an investment advisor or look at investing in Equity Mutual Funds. Investing in stocks is risky since predicting the performance of a company or the market demand is virtually impossible. Therefore, diversification helps you hedge against these risks to a great extent.
Apart from buying shares of different companies, it is also important to diversify your overall investment portfolio by investing in other asset classes like gold, real estate, etc.
There is no doubt about the fact that investing in stocks can be financially rewarding. However, it does involve risks and requires careful planning. Research the market well and create an investment plan before you start investing in stocks.