Why stock markets are not risky
By: Abhilash J
Tags: Indian Investor, Stock Market, Profit, Risk, Investing

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.