The difference between investing and trading
Investors are people who buy assets (in this case, stocks) in anticipation of long term appreciation in their value. Traders are people who buy (or short sell) assets, expecting to profit from short term appreciation (or decline) in their value.

So can be observed, investing and trading are two totally different activities.

Long term and short term investing
Investors buy assets (in this case, stocks) for the long run, typically for periods in excess of 5 years. Medium term investors invest with time horizons of 1-3 years while short term investors invest with time horizons of les than 1 year. Traders and speculators hold positions for short periods lasting less than 1 year. Day traders hold positions for less than 1 day at a time.

Returns to be expected from investing
Before one starts investing/trading, it is important to have a rough idea of the kind of return to be expected. Returns from investing in broad-based developed market indices over long periods (30 years +) tend to be about 10-12 % p.a. Returns from emerging market indices tend to be higher than those from developed market indices. Investing in individual stocks is more risky than investing in diversified portfolios and often yields more than investing in broad based indices.

Returns to be expected from trading
Returns from trading stocks vary significantly and could theoretically range from negative infinity to positive infinity. Speculative investments in stocks have often yielded over 100% in a single day, just as they have also resulted in returns of minus 90% over a few hours. This kind of volatility is especially present in penny stocks and stocks of companies in emerging markets. Trading is risky business and therefore should be approached with caution by beginners.

Risk
Risk here, is defined as the volatility of returns. For the sake of quantification, risk is taken as the standard deviation of the returns earned from an investment.
Assume that Stock A’s monthly returns are 5%,-6%,10%,1%,-8% and that Stock B’s returns are 1%,0.2%,0%,-0.2%0.2% .Stock A is considered more risky than Stock B since its standard deviation of returns is 7.5% while that of Stock B is 0.45 %. That is despite the fact that Stock A has a higher average return than Stock B.

Risk and Reward
In the world of investing, the reward that an investor gets depends heavily on the risk that he/she is willing to take on. Government bonds are the least risky and could yield anywhere between 1% and 5% p.a. depending on the maturity of the bond, the issuing government, the currency of issue and the prevailing interest rates. Bonds of robust companies with fairly certain cashflows yield more than government bonds while bonds of companies with poor credit ratings yield even more. Stocks and real estate typically have the highest average return as well as the highest risk(volatility of returns) among all asset classes.

If one desires a high return, she must be willing to take on a higher amount of risk. It is improbable that one will consistently be able to find investments with low risk and high return.

Further Reading

I would recommend  the book,“A Random Walk Down Wall Street” to those interested in reading more about the basics of investing.

Bid-Ask Spread
Stock brokers charge clients a commission for executing their trades. They also earn money from the bid-ask spread. Example – If you ask a broker for a quote for 1 share of Citi and receive the following price: “3.10, 3.20”, it means that the broker is willing to buy(from you) 1 share of Citi for $3.10 and sell(to you) 1 share of Citi for $3.20.

Here, the bid price is $3.10 and the ask price is $3.20.Notice that if the broker buys 1 share at $ 3.10 and sells it at $3.20, she will make a profit of $0.10 . This difference in the ask price and the bid price is known as the bid-ask spread.

Brokers
Cost is a very important consideration in choosing a broker as commissions and spreads can add up to a substantial sum especially for active traders. Most brokers allow clients to place orders online or via telephone. Deep Discount brokers charge very low commissions and can provide reasonable execution. Most brokers also offer access to global markets. Therefore, it should be possible for a trader based in Singapore to buy stocks traded on the NYSE through his broker in Singapore.

Costs
Commissions typically amount to about 0.25% of the value of the trade. The catch here is that most brokerages charge a “minimum commission”. That would imply that the client could end up paying $20 as commission for buying a stock worth $1. Minimum commissions vary across countries. They typically stand at around US$10 in USA, SGD 25 in Singapore and INR 25-50 in India.* Some brokers offer very good “per-trade” rates subject to a minimum number of trades every month.

The broker not only executes trades on the client’s behalf but can also provide research reports that help clients make better trading decisions. Different levels of service are available for different fees. These usually pertain to trade execution and research reports. In my opinion, beginners need not lose sleep over these details.

Some Brokers
USA:  Charles Schwab, E-Trade
Singapore: Kim Eng Securities, CIMB
India: HDFC Securities, ICICI Securities

* Clients should contact their brokers for detailed information in this regard.

Rights of the shareholder
Shareholders collectively also appoint the board of directors of the issuing company and typically approve/reject major decisions taken by the board such as the issue of new shares, mergers and acquisitions etc. In case of bankruptcy of the issuing company, shareholders also have a claim on the assets of the company, though their claim is subordinate to that of bondholders.

Trading of Shares
Shares are most often traded on stock exchanges. In order for a company to enable its shares to be traded on an exchange, it has to list its shares on the exchange. The issuance of shares by a company and their subsequent listing on a stock exchange for the very first time is termed an Initial Public Offering (IPO).

Dividends
Investors expect to be compensated for investing in the shares of a company. To compensate investors, companies typically pay their shareholders a part of their income every year. This payment is known as a dividend payment.It is not legally binding on a company to pay dividends. In fact, several companies do not pay dividends for several years together, preferring to re-invest their earnings in the company’s operations.

Capital Gains
Increases in the price of shares result in capital gains. If the market value of a share is greater than its purchase price, the difference between the market value and the purchase price is the unrealized capital gain. If a stock is sold at a price greater than its purchase price, the profit is known as the realized capital gain.

Total Return
The total return to the shareholder consists of the dividend income and the capital gain on the share.
Total Return = Total Dividends received + Capital Gains

Types
There are two main types of stocks – Common stock and Preferred stock.
Common stocks give their holders ownership in a company and claim on the assets of the company in case of bankruptcy. In addition, they also give holders voting rights when important corporate decisions are put to vote at shareholder meetings. Common stockholders typically receive a dividend from the issuing company at its discretion.

Preferred stocks are hybrids between debt and equity instruments that give their holders a higher priority claim over the assets of the company than common stocks. Preferred stock holders receive fairly certain fixed dividend payments every year but typically do not have voting rights. The scope for capital gains on preferred stock is rather limited.

Valuation of shares
Shares can be valued in several different ways. Analysts use complex models to value shares of different companies. These models fall into two categories:

1. Discounted cashflow models
2. Multiple models

Discounted cashflow models discount the cashflow that is expected to be received from the stock, typically in the form of dividends, using a discount rate that is reflective of the risk associated with the investment.

Multiple models use a market-based multiple of a fundamental parameter of the company to value the stock of that company. For example, the earnings multiple model values a stock as a given multiple of its earnings per share. Therefore, if the appropriate earnings multiplier is 15 and the earnings per share of a company are $1 per share, the value of each share of that company is $15.

We will cover different valuation methods in detail in another article.

The List

1. Reliance Industries – Petroleum Refining and Petrochemicals
2. Tata Motors -  Automobiles and parts (cyclical)
3. Tata Steel – Metal (Cyclical)
4. Tata Consultancy Services – IT
5. Infosys – IT
6. ICICI Bank – Finance (semi-cyclical)

More later.

No Leverage
Suppose that the stock (GS) is trading at 70$ per share today and you expect the value of the stock to go up to $80 in 2 months. If you invest $1000, you will be able to buy $ 1000/ $ 70 = 14.29 shares (For the sake of simplicity, assume that you can buy fractions of a share) . If the  stock does move to $80 in 2 months and you sell your shares, you will end up having 14.29 * $80 =  $1143. This is a profit of $143.

With Leverage
Suppose you borrow $2,000 from a bank and use this amount in addition to the $1,000 that you already had to buy Goldman stock, you would have $3000/$70 = 42.86 shares. At the end of 2 months, if the stock does indeed rise to $80 per share and you sell you shares, you will have 42.86 * 80 = $3429 . You will have to pay back the $2000 that you borrowed from the bank. Thus you are left with $3429 – $2000 = $1429. This is a profit of $429 , which exactly 3 times $ 143 (the profit earned in the previous case).Thus, you have effectively tripled your profit using leverage aka borrowed money.

There is no such this as a free lunch
If leverage is so great, why doesnt everybody use it? What is the downside? The answer lies in the fact that leveraged is a double edged sword. It magnifies your profits as well as your losses. Let us use the previous example to explore this assertion. If Goldman stock, instead of rising to $80 per share, fell to $60 a share and you sold your holdings, you would have had $60 * 14.28 = $856.8 which would have resulted in a loss of about $143. If you had used leverage, you would have had had $60 * 42.84 = $ 2570 which would have resulted in a loss of about $429 which is exactly 3 times the loss without leverage.

In essence, we are magnifying the exposure that we gain, to changes in asset(shares etc) prices, through the use of borrowed money.

Common forms of Leverage
The most common way people lever their trades is by using something known as margin trading. When you trade on margin, you are essentially borrowing money from your broker and investing it in the stock market/whichever market you are trading on. You typically pay interest on the borrowed money. We will talk more about margin trading later.

Though not involving the use of borrowed money, CFDs (Contracts for Difference), futures and options are other ways to magnify your exposure to movement in the prices of assets. These instruments are essentially contracts and we will deal with these instruments in later posts.

The moral of the story is – Leverage is a great tool . Use it wisely and carefully lest you lose everything including your shirt.