Why Invest in the Stock Market

Stock market in India has been out of reach for a vast majority of Indians until very recently. Thanks to the liberalized policies and streamlined investment banking business in India, Indian Residents can now participate in the stock market of India. It is no longer for the rich and famous people.

In my previous blog post on A Simple Guide to Stock Market Investing in India, I talked about how Indian Residents and NRIs can invest in the Indian stock markets. In this blog post, I will discuss fundamental reasons why we should invest in the stock markets.

First of all, your goal for any investment should be to generate returns that outpace the inflation. As you know, The inflation rate in India was last reported at 9.5 percent in March of 2012. From 1969 until 2010, the average inflation rate in India was 7.99 percent. Looking at these figures, you need your investments to return at least 9 percent to break-even with inflation and above 9 percent to make money. Just to give you a simple example...the cost of milk in 1990 was 10 rupees/litre, now in 2012, milk costs about 40 rupees/litre. Like milk, everything else has become expensive. So, you need your investments to outpace the inflation, otherwise, your money will deplete faster as inflation keeps rising.

Over a long period of time, stock markets have historically provided better return on investments than any other investment vehicle be it real estate, gold, bonds, fixed deposits, or anything else. The reason for this performance over extended period of time is the effect of compounding.

When you purchase a share of a company, you will receive certain amount of profits generated by the company in the form of dividends each year. When a company makes a profit, it needs to decide what to do with it. Most companies return part of their profit to their shareholders and invest remaining part for their own growth. When a company invests its profits for its own growth, it does so to gain additional market share, retain its current customers, improve its products, or develop new products or markets. What this means is that the company wants to grow (not just in size, but also in revenue). When the company grows, it results in even higher profits for the company in the future. When shareholders see higher profits, they purchase even more shares. When there is more demand for company shares than the supply, it results in the appreciation of its value.

Let me get back to the point of compounding. When you receive dividends and choose to re-invest those dividends (highly recommended), then every year you receive those dividends, you are purchasing shares with those dividends. Those purchased shares generate further dividends in the future, which, in turn, will be used to purchase additional shares. This cycle continues as long as you keep owning those shares and keep re-investing your dividends. Before too long, you will start to see the the effect of compounding. Your stock market investments will appreciate even faster if you hold those investments for a long period of time.

So, we talked about dividends and capital appreciation. Both these components together make up the return for your investments. You should use both to understand your true return on investments.

Let me briefly explain why you should hold investments for a long period of time. As explained previously on the effect of compounding, the longer you hold your investments, the more time it has for your investments to compound. Another reason to hold investments longer is because it normalizes the short-term ups and downs of the stock markets. The normal tendency for investors is to panic when they see stock markets go down and become exuberant when they see stock market go up. Lots of people sell their investments during the panic -- this panic happened in 2008-2009 stock market crash. But, if you keep your emotions in check, such stock market crashes present unique opportunities for patient investors to buy shares at rock bottom prices. When the stock markets rebound, these patient investors are rewarded handsomely in the form of higher capital appreciation.

Many people ask me opinions on investing in gold or real estate. These two asset classes have appreciated quite significantly in the last 10 years. My typical advice to both these assets is NO. The reason I don't personally like these assets is because their return on investment comes only in the form of their price appreciation. If there is a buyer willing to buy these products at higher prices than demanded, then prices will continue to appreciate. But, like everything in life, there is only so much the prices can grow. Prices can grow only as much as people can afford, otherwise there would be no buyer.

Instead, if you invest in a stock market, a company has limitless potential to grow and there is always an innate need for companies to keep growing, otherwise, they would be crushed by competitors. Additionally, you and I are employed by companies. So, you and I want companies to grow so we can keep our jobs. And most people work hard to keep their jobs. Because of this innate drive, a company can grow from 1 plant to 10 plants. But, a piece of real estate or gold, will remain same as when your purchased it. Your 1 acre of land will only remain 1 acre when you sell it. But, that is not true of companies. Also, gold and real estate investments are highly ill-liquid, meaning, you cannot easily sell those unlike shares. For these reasons, I do not recommend gold or real estate for investment purposes.

I hope this post provides you with enough information to help you decide whether or not to invest in the stock market.