Equity Investing: Part 1 - Basics

I have the enormous privilege of immersing myself in what I genuinely enjoy - investing.

Many a time, I've been asked about it. Most people want to know - how they can participate, how stocks are selected, what the atmosphere in a trading room is like, and how one can earn millions? Someone once asked me if I could make them Richie-Rich overnight.

The not-so-exciting, but accurate answer is - investing resembles any other craft. Like cooking, sculpting, carpentry, or sports. To learn about it is relatively easy, but true proficiency comes from performing it over, and over, and over again.

This article kicks off a series of posts, intended to introduce the reader to the game of investing. While knowing fully well that it would only be a drop in the ocean! I plan to do it in parts. That said, let’s dive in.

In "Part 1 - Basics" we'll cover some elementary questions which should give us a base to build on in the next articles.

1. What is a business?
2. What is a company?
3. What is an equity share?
4. What are stock markets and stock exchanges?
5. Who is a stock broker?
6. What's a trading and demat account?
7. How does one make investing decisions?

Please skip to whichever heading you want to read about by clicking on it. And if you wish to skim a section, just read the text in bold.

What is a business?

A business repeatedly delivers something that's useful for society, in return for money. A business has many motives, the primary ones are :

• The service angle - being a useful contributor to society and the economy,
• The profit angle - generating a return on capital,
• The human angle - providing meaningful employment, with opportunities for learning and growth.

What is a company?

A company is something which is artificially created for human convenience. A company has an existence of its own, beyond its owners. Which means that it can

• own things (like property, stock, etc.), and
• enter into agreements (business contracts, providing employment, etc).

Hence, a business can be run under the name of a company. This allows for collaboration and business continuity. So people can start businesses together and the business can live on even after the person(s) who started it has moved on to something else.

What is an equity share?

An equity share is a small ownership piece in a business. It's easier to understand it through the following example -

Say you want to start a car rental business. First you must buy a car. If that car costs 1 Lakh rupees, you need that much money just to start your business.

Now, say that you and your best friend contribute ₹60,000 and ₹40,000, respectively. And become 60% and 40% owners of in a newly formed company. Now, you can buy the car in the name of this company.

In future if either of you need, say ₹15,000 - you would prefer to sell only that much of your stake in the company, which gets you the ₹15,000 you need, instead of having to sell your full stake. The concept of equity shares makes dealing with such situations easier - by denoting the entire stake of the company in small parts. Think of it like equal sized puzzle pieces. In this example - 10,000 puzzle pieces, each worth ₹10. All the pieces put together, equal to ₹1,00,000. Thus, now if you need ₹15,000, you just have to sell 1,500 equity shares.

To sum it up, think of the word equity to mean ownership, and the word share to mean small puzzle piece where the entire puzzle denotes the entire stake.

What are stock markets and stock exchanges?

Any market is simply a place where buyers and sellers meet and transact.

In case of stocks (another name for shares), a stock market is a place where buyers and sellers of stocks meet and transact.

Think of a stock exchange the way you think of a flea market. A certain person organises it; allots space to sellers for their shops and promises them that people will visit. And they might buy, if they like. So, the organiser promises demand to the suppliers and supply to the demand-ers.

The National Stock Exchange is the largest stock-flea-market in India. Meaning, it is the market where the maximum volume of (stock) transactions happen in India.

There can be multiple stock exchanges in a country. BSE is another popular stock exchange in India.

Who is a stock broker?

A broker is someone who sells something on behalf of someone else.

Stock brokers provide access to one or more stock exchanges with whom they have membership.

Much like membership at a club, if you want to visit say the Rotary club, you can only do so if you're a member, or if a member invites you. You can only access the NSE-club where shares are bought and sold, along with a member - an NSE broker. (PS - there is some talk about allowing investors to directly deal with exchanges, without the need of brokers)

Along with access to the stock exchange, brokers usually provide additional services like advisory, dematerialising physical shares, maintaining demat accounts, etc.

What's a trading and demat account?

Actually, a trading account and a demat account are two separate things. Though they are often maintained by the same broker.

A trading account can be thought of like a bank account. When you transfer money into a new bank account, that money is still in your name, it doesn't belong to the new bank. Similarly, when you transfer money into a trading account (maintained with a broker), it's still your money lying with the broker. Which you can now use to buy shares from the stock market.

A demat account is a digital safe where shares are kept. This was started to solve the problems like spoilage, theft and loss of paper shares. The way a bank account digitally shows how much money we have, a demat account shows the names, the quantity, and the current market value of shares we own.

How does one make investing decisions?

The most interesting part! Also, the most elusive!

Investing is nothing but buying with the desire to sell at a higher price. (and earn from the asset, by way of - rent, interest, or dividend)

It's like predicting the future. Which is why, it will always be an inexact science.

Math is an exact science. 4 + 5 = 9. Always.

But investing doesn't work that way. Doing it well only increases the odds of success, but it never guarantees success.

Coming back to the question, two popular approaches are used to make investing decisions. They are -

1. Using the information generated in the business - like sales, profit, etc. - users of this method focus on the fact that - a share represents a business, and if the business does well, the share price will also increase. So to be successful, one must value the business and use that as a guide to make investment decisions.
2. Using the information in the market - like price, volume of transactions, etc. - users of this method focus on the fact that - money is made by buying low and selling high, irrespective of what the business does. By playing the market well, they feel they can be successful. So they focus on market information only.

We'll dive into both of these in the coming weeks.

PS - to improve clarity, this article has been updated on 13th August 2020.