Like fire, equity investing also requires that we understand the destructive power, and manage the risks.

  Fire was probably the first discovery made by mankind. It is a powerful tool. On one hand, it can cook food for men. It can also cook men. Hence the popular proverb  “Do not play with fire.” But it has never been said “Do not use fire.” Fire has its uses and needs to be harnessed. The same can be said about so many things in life. While fire is a simple example of how something with devastating powers can be harnessed for human good, there are some complex things with similar risks and characteristics that many of us do not understand. Take for example, the world of investing.

  There are so many inventions in the field of investing, most being with the intent of helping individuals either benefit through exploiting opportunities or through reducing the risks. The stock markets are designed to channelize household savings into productive investments for various businesses. The liquidity in the stock market allows companies to raise long term funds without the investors having to lock their savings for a very long period. Even if there is a mismatch between the requirements of a company and that of an investor, the stock market provides opportunities for the investor to get out of the market with reasonable ease.

  While stock markets fulfill an important economic function, due to the actions of many investors at various points in time, the prices of stocks fluctuate a lot. Often such fluctuations are beyond reason. Such up and down movements make stock markets very similar to the example of fire used in the beginning.

  On one hand, the stock market can help an investor create wealth. On the other hand, it can take away all the wealth one may have created by saving money throughout one’s working life.

  The similarity is striking, but our respective attitude towards both is vastly different. While we have learnt to harness the power of fire, stock markets look scary to most people. Whereas the approach in the case of fire is just “Do not play with fire”, for stocks it becomes “Stay away from stocks”.

  Such an attitude is evident in the low allocation one makes to the stock markets out of household savings. A lack of understanding about the nature of stock markets magnifies the risk. Such magnified risks turn into fear, which keeps many investors away from this powerful investment option. However, in the process, one is unable to generate real returns on one’s investment portfolio. Real return is what is left after inflation. Real return is the positive wealth created after adjusting for the reduced purchasing power of the Rupee.

  Taking the analogy of fire further, equity investing also requires that we understand the destructive power, manage the risks and control our emotions. Sometimes, many sane investors get carried away when it comes to their investments. It might be a good idea in these times to have wise advisors who have a balanced outlook and have seen various market cycles. The help and experience of such people often acts as protection against the occasional bouts of irrationality. Again, it is important to ensure that the advisor has a balanced head on their shoulders, understands the subject of investments well and has either been through or read about various market rallies and crashes.

  At this juncture, it is important to grasp that mankind has taken centuries to fully understand and appreciate what fire can do and learn to harness its power. Compared to that, equity investing is a relatively new field. Looking through the history of financial markets, it appears that equity markets are only a few centuries old. Add to that the fact that most of the devices and tools that we use in case of fire are mechanical or non-living, i.e. without emotions. Equity investing requires us to involve ourselves in certain analyses and decision making – both of which may be influenced by emotions. And it is the emotions that can be one’s enemy. This is exactly what guru Benjamin Graham said “The investor’s chief problem – and even his worst enemy – is likely to be himself.” Or as the Nobel Prize winner Daniel Kahneman said “Psychology has a story to tell about investing, and it’s different from the one Economics tells.”