The investor would want to invest mainly to increase the rate of return on his assets. Through our need to create a source of income, an additional source of income or to further create an asset base to fund future requirements (like a personal pension fund).
Let us consider why people invest. A person does a job of work to earn an income. At the end of the month he manages to save a residual amount of his income. Which after a period of time would add up to a substantial amount (given the added advantage of interest on bank balances). The person may have received an inheritance or a legacy. This too is lying in the bank. All this money which is lying in his bank account is earning only the savings bank rate, which would be 4% to 6% per annum.
The person is rational and knows that today even inflation ranges from 5% to 7%. He realizes that leaving the money in a savings bank account would tantamount to losing the value of money over time.
To stop this loss of value, he decides to shift the money not required for current expenses into a 3-5 year fixed deposit. Here he is able to get an interest rate of 7% to 8% per annum. By definition this person has invested his money. As he has employed the money in the present, to increase the rate of return in the future.
The aim is clear (to obtain a higher rate of return, that is above the inflation rate), the financial instrument is available (Fixed deposit), the investment risk is known (which in this case is zero) and the person goes ahead and invests.
Let us consider another situation. The person reads many news papers. In each of them he sees a business section. Which has a whole page dedicated to the equity price movement of the previous day, for all the stocks traded in the equity markets. With graphs depicting the movement of the index over the duration of the previous day.
He looks through this page every morning and starts monitoring a particular stock, let's say ACC. He sees the stock at ₹220.00 per share. Over, the next 3 months, he sees it move up to ₹260.00 per share. Now the stock is at a price ₹40.00 higher. This sounds good.
He does a little maths and sees that if he had bought 100 shares of ACC at ₹220.00 per share, he would have invested ₹22,000.00. In three months time he would have brought home a profit of ₹4,000.00, that is a 18.18% return on investment over a 3 month period. This is fantastic!! No bank is going to give this kind of return!
A month later he buys 100 shares of ACC at ₹280.00 per share, investing ₹28,000.00. In the next two months he sees the stock down at ₹250.00 per share. Disillusioned, he sells his 100 shares and books a loss of ₹3,000.00. Promising never to gamble again. After another three months ACC was trading at over ₹350.00 per share.
What went wrong? Well, in this case the person had not considered the 5 questions. He did not have an aim to start with. There was only temptation and probably greed.
The point I am trying to make here is that when we expect a higher rate of return on our investment, we are also exposed to a higher level of risk. That we must respect this risk and take appropriate steps to manage and control it.
Given the situation in parts of the world today, with the ongoing and continued liberalization and globalization process; and circumstances of an economic slowdown in certain important countires. It would be rational to expect that interest rates would remain at a lower level when compared to earlier years to enable a recovery of these countries in economic distress. This lower interest rate (or cost of capital) would enable industry and services sector to be more globally competitive. Thus, given a lower level of return to individuals from bank deposits and other debt instruments, more funds would be deployed in equity and other financial instruments to increase the rate of return on their assets.
With the passage of time other real time circumstances may face the economy of various countries, where the interest rates may have risen with a regulatory view to control a higher level of inflation caused due to a higher level of growth given the earlier low interest rate scenario. On occasion, it may also be the result of supply side constraints, resulting in an inflated price for the lesser number of products and services available not able to meet and provide for an increased level of demand for them.
This increased interest rate regime on a first glance would not appear to be conducive to equity investment, as the cost of capital or investment capital has risen; further, that debt and other interest bearing financial instruments would appear to be more attractive given a raised level of assured return with little or no risk. Alongside, the prices of even the lead stocks traded in the stock market would have declined to levels far below their intrinsic value. A gloom and doom scenario would appear to hang over the stock markets; where everyone would be happy to sell their stocks. But, this would be precisely the period of time when stocks would be available at deep discounts to their intrinsic value and a hunting ground for the value investors who are willing to wait their turn to make their gains and profits sometime in the future. The period of holding such stocks would probably extend from a few months to a year or even longer on some occasions.
Value investing on most occasions would appear to be contrarian and would demand a higher level of discipline and fortitude from the investor. However, as long as the investor stands true to his reasons (the "Why" in this case) for investing in the stock markets he should be able to gain above average returns from his investments in the long run.