Knowledge is the key to success in investing

A major proportion of investors are unable to create substantial wealth due to a lack of knowledge about investing, the power of equity to create wealth, and how equity investment actually works.

India's digital leap over the last few years has transformed the way we communicate, shop, book tickets, and do a lot of other things. However, the way Indians invest largely remains the same. According to popular estimates, even today, less than 2 percent of the Indian population invests in the stock market.

As times have changed, equity investment is now convenient and can be done online in a few clicks or even on your smartphone instantly. However, a major proportion of investors are unable to create substantial wealth due to a lack of knowledge about investing, the power of equity to create wealth, and how equity investment actually works.

Let’s take a detailed look at these aspects to understand why ‘knowledge is the key to success in investing.’

Why it is important to invest in equity for wealth creation?

Traditionally, Indians have preferred investing in fixed deposits, post-office deposits, real estate, and PPF as that’s what their previous generations did, and have been passing on the same.

Investments in the above options were justified decades back as interest rates were high, and awareness about equity investments was very low. Times have drastically changed now as interest rates are on a downward trend, making PPF, bank deposits, and post-office deposits less attractive.

While these instruments carry less risk as compared to equity, they are also inadequate to beat inflation. Considering the current inflation rate of about 5 percent, when one invests in a bank FD that offers 6 percent interest per annum, the real rate of return on the investment is only one percent (6-5 percent).

Real estate, too, has lost its sheen over the last few years in the aftermath of the government's demonetisation drive in 2016.

According to recent estimates, the number of unsold inventories in real estate properties remains at an all-time high in cities across major cities in India, which has made real estate an unattractive investment.

In such a scenario, equity is one of the best investment options as it can not only beat inflation but also generate double-digit returns in the long run. Historic data also reveals that equity has beaten all other asset classes by a huge margin over the last few decades.

How equity investment works? The process to create real wealth

Legendary investor Warren Buffet describes the stock market as an instrument for transferring wealth from the impatient to the patient.

This is true because most investors view stock markets as an option for becoming rich overnight. As a result, they often fall into the trap of investing based on generic tips from random sources or trending stocks without looking at the fundamental strengths of a company.

While in the short-term, stock prices are driven by news and the market demand and supply, in the long run, it is always the fundamental and financial strengths of the company that drive the stock prices upwards.

The real way to create wealth from stocks is by investing in fundamentally sound stocks after detailed research and waiting patiently.

To evaluate the fundamental strengths of a company, one should look at its key financial ratios, including price-to-earnings ratio (P/E ratio), price-to-book ratio (P/B ratio), debt-to-equity ratio (D/E ratio), free cash flow (FCF), PEG ratio, its management pedigree, scalability of its business model, and consistency in earnings over a long-term period.

One must always remember that when investing in the stock of a company, one is purchasing part ownership of the company. So, it is important to give adequate time for the company to grow and realise its true potential.

When the company does well, its stock price automatically follows. It is also equally important to invest in companies whose market scenario and business one understands.

Volatility is an indispensable part of the stock markets. However, by investing in fundamentally sound stocks after thorough research for the long term, any investor can create substantial wealth. This is a proven and time-tested method for creating impactful multi-generational wealth.

Edited by Suman Singh

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)