All you need to know about investing
Investing is either you lending money or taking a stake in a business. As simple as that! When you lend money, there is generally a promise of return of amount, you may or may not charge interest on it. And, when you take a stake in business, it’s almost like becoming a ‘silent partner’. You take risk to get a share of the upside; there is no interest or promised return; you gain if the business becomes more valuable and lose if it becomes less valuable; there is no automatic return of capital.
To classify more clearly, if you choose the first option i.e. lending money, you are investing in debt. If you choose the second option, you are investing in equity.Debt and equity can be further divided into:
- Debt can be short term (if you lend for less than 12mths) or long term (more than 12mths) and called fixed income where you get an annual interest rate
- Equity usually has an interest into a business, but can also be into a property; when you invest in property or real estate, you get a stable rent (similar to fixed interest though the tenant can default) and some capital upside (similar to equity)
These categories are called asset classes. Asset classes refer to a group of financial investments that are similar. These can be further divided on the basis of:You can divide asset classes into further categories based on
- Risk, including real risks such as credit risk or business risk, or market risks (fixed interest could be divided into government debt, investment grade, corporate debt, high yield debt; equities could be divided into large cap and small cap etc)
- Geography, which could be global, regional, country-specific (equities could be divided into domestic equities, international equities, emerging market equities etc)
- Liquidity, (equities can be divided into listed equities, private equity)
- Focus, which could be broad-based or sector-specific (equities could be divided into large cap and small cap etc, or into industrials, resources, REITs etc)
Debt and equity require different focus
So, how do you decide how to invest- should you lend money or become a silent partner? The first thing that you should look for is the potential for the business.
If you decide to lend, you should know what interest would you get? Most importantly, how and when will the lender pay the capital back? Is he buying an asset with your money that you can take as security? Or can he give you something else as security? You then have to weigh up the security of your capital with the interest he has offered.
On the other hand, if you decide to become a silent partner in, let’s say, a friend’s business, the focus of your questions might become more future-oriented. In addition to the earlier questions, you may want to know how much profit the business will make after paying staff, rent, and the interest on any loans he might have taken. You might ask whether they intend to pay out dividends or re-invest in the business; for example, a new location. After you are convinced about the business potential, you may want to know how much stake you would get.
What then is the stock market?
The different people coming to make you different offers on your stake in a business are collectively known as the ‘market’. It’s no different to the market for anything else – think of the vegetable or fish market. A grower may stand with his produce and different people will offer different prices to buy his produce. To make the process of bidding easier, somebody might put up a notice board on which the grower could put his asking price and buyers can put up their offer price. The grower might then accept the highest offer.
The stock exchange is basically such a notice board. It just reflects the various bids and offers on all the companies’ equity components – and the people bidding make up the market.The market reflects all the bids for all the companies listed on the stock exchange. The last price on which the stock traded is considered the market price i.e. the price at which a willing buyer and willing seller were willing to transact.
When the market price of a lot of stocks goes up, the ‘market’ is said to be going up. And when the market price of the majority of them go down, the market is said to be going down. To capture these movements, some people come up with an index; it’s a hypothetical basket of shares made up of one share from a set of companies selected on the basis of some criteria. So when market price of these shares go up or down, the index reflects that.
Note that the market is there just to tell you what you could get in case you want to sell your stake. You don’t actually have to sell at that price. You could wait until the prices are higher. There is a separate bond market for the debt component of the companies too, which works on the same principles.
**Mutual fund investments are subject to market risks, read all scheme related documents carefully
Hansi Mehrotra, CFA is a financial educator who writes and speaks on various platforms, getting named as a ‘Top Voice for Money and Finance’ on LinkedIn for 2015. Hansi has more than 20 years experience in financial services.