Stock Market Basics: Frequently Asked Questions (FAQs) by investors and traders

What is sector rotation?

Sector rotation is an investment strategy that involves shifting investments among different sectors of the economy based on their performance and economic cycles. The idea is to capitalize on the cyclical nature of various sectors, as some perform better during certain economic conditions while others may lag.

Key Points:

1. Economic Cycles: Different sectors respond differently to economic changes. For example:
   • Cyclical Sectors: These include industries like consumer discretionary, technology, and industrials, which tend to perform well during economic expansions.
   • Defensive Sectors: These include utilities, healthcare, and consumer staples, which tend to hold up better during economic downturns.
2. Timing the Market: Investors use sector rotation to take advantage of these shifts by reallocating their investments. For example, during a recession, an investor might sell stocks in cyclical sectors and buy stocks in defensive sectors to mitigate risk.
3. Indicators: Investors often use economic indicators (like GDP growth, unemployment rates, and interest rates) to predict which sectors are likely to perform well or poorly, guiding their rotation decisions.
4. Portfolio Diversification: Sector rotation can help maintain a balanced and diversified portfolio by ensuring exposure to sectors that are expected to thrive under current economic conditions.
5. Active Management: This strategy often requires active management and monitoring, as investors need to stay informed about economic trends and sector performance.

In summary, sector rotation is a dynamic strategy that seeks to optimize returns by aligning investments with the changing phases of the economic cycle.

What is a market correction?

A market correction is a decline in the price of a security or an index of at least 10% from its recent peak. Corrections can occur in any financial market but are most commonly associated with the stock market.

Key Points:

1. Short-Term Decline: Corrections are typically seen as healthy adjustments after a period of rising prices. They can occur over a short timeframe, often lasting a few weeks to a few months.
2. Reasons for Corrections: Various factors can trigger a correction, including:
   • Overvaluation of stocks
   • Changes in economic conditions or interest rates
   • Negative news or earnings reports
   • Geopolitical events
3. Investor Reaction: While corrections can create anxiety among investors, they are generally viewed as normal market behavior. Many investors use corrections as buying opportunities to acquire undervalued stocks.
4. Distinction from Bear Markets: Corrections are different from bear markets, which involve declines of 20% or more and typically indicate a longer-term downturn in market conditions.
5. Market Dynamics: Corrections can help stabilize the market by allowing overvalued stocks to reset, making way for more sustainable growth in the long run.

In summary, a market correction is a temporary decline in prices that serves as a natural part of market cycles, allowing for adjustments and potentially presenting investment opportunities.

What is a recession?

A recession is when the economy slows down for a while. During a recession, businesses make less money, people lose jobs, and people spend less. This usually happens when the country’s total production (GDP) falls for two or more quarters (6 months).

Example: If many stores are closing, people are losing jobs, and fewer people are buying products, the economy might be in a recession.

What are the effects of government policies on the stock market?

Government policies can have a big impact on the stock market. When the government changes things like taxes, interest rates, or how much it spends, it can affect businesses, consumers, and investor confidence.

Example: If the government lowers interest rates, it becomes cheaper for people and companies to borrow money. This can encourage spending and investment, which can help stock prices go up. On the other hand, if taxes are raised or interest rates go up, it might slow down the economy and cause stock prices to drop.

What is the role of the Federal Reserve and RBI?

The Federal Reserve (Fed) in the U.S. and the Reserve Bank of India (RBI) in India are central banks. Their main role is to manage the country’s money supply and interest rates to keep the economy stable.

1. Controlling Inflation: They try to keep prices stable by controlling how much money is in circulation.
2. Setting Interest Rates: They set the interest rates, which affect how expensive it is to borrow money. Lower rates encourage spending and investment; higher rates can help slow down the economy if it’s growing too fast.
3. Supporting Banks: They help banks stay stable, especially during financial crises.

Example: If the economy is slowing down, the Fed or RBI might lower interest rates to encourage people and businesses to borrow and spend more. This can help boost the economy.

How are capital gains taxed in India?

In India, capital gains are taxed based on how long you hold an asset before selling it. There are two types of capital gains tax: short-term and long-term.

1. Short-term capital gains (STCG): If you sell an asset like stocks within 1 year of buying, the profit is considered short-term.
2. Long-term capital gains (LTCG): If you hold the asset for more than 1 year, the profit is long-term. 

Example:

• If you buy a stock for ₹100, sell it after 6 months for ₹150, your ₹50 profit is a short-term gain.
• If you sell the same stock after 2 years for ₹150, your ₹50 profit is long-term.

These tax rules apply specifically to listed equity shares and mutual funds. Other assets like real estate have different tax rules.

What is a tax loss harvesting strategy?

Tax loss harvesting is a strategy where you sell investments (like stocks or mutual funds) that have lost value to realize a loss. This loss can be used to offset gains from other investments, reducing your taxable income.

Here’s how it works:

1. You sell an investment that’s worth less than what you paid for it, locking in a loss.
2. You use that loss to reduce your overall taxable capital gains or even other types of income, like your salary.
3. After selling, you can buy a similar investment again (but not the same one) to keep your portfolio balanced.

Here’s an example based on the Indian context:

Example:

• Selling Loss-Making Stock:
  • Let’s say you bought 100 shares of Stock A for ₹50,000 (₹500 per share).
  • Over time, the stock price drops, and you sell the shares for ₹40,000 (₹400 per share).
  • Now, you have made a loss of ₹10,000 (₹50,000 – ₹40,000).
• Using Loss to Offset Gains:
  • You also sold 50 shares of Stock B for ₹30,000 (₹600 per share), which you had bought for ₹20,000 (₹400 per share).
  • Here, you made a gain of ₹10,000 (₹30,000 – ₹20,000).
• Offsetting Taxable Gains:
  • Your ₹10,000 loss from Stock A can be used to offset the ₹10,000 gain from Stock B.
  • This means no taxable capital gain in this case, so you pay zero tax on the gain from Stock B.

By using tax loss harvesting, you can lower your tax liability legally and efficiently, especially in a year when you’ve made gains from other investments.