A Beginners Guide to Investing in the Stockmarket
For those with no experience investing in the stockmarket via company shares can seem like a daunting prospect and potentially high risk. However, with the returns being offered by savings accounts with banks and building societies generally coming in at below inflation, investing in shares is one of the most accessible options retail investors have to achieve greater returns or simply hedge against inflation.
In the UK the main stockmarket is the London Stock Exchange (LSE), where public limited companies as well as other financial instruments such as government bonds, derivatives and certain kinds of funds and trusts are bought and sold. Other major international stockmarkets include the NASDAQ and NYSE in the US and the Tokyo Stock Exchange in Japan. The stockmarket is a free market mechanism with the price of the different company shares and other instruments fluctuating depending on supply and demand.
The stockmarket is broken down into different indices which group companies together under specific categories and track the performance of that category as a whole. The most famous in the UK is the FTSE 100 which is comprised of the biggest 100 public limited companies listed on the LSE by market capitalisation (the total value of all the company’s issued shares). FTSE is an independent company which creates the indices. Other popular FTSE indices include the FTSE 250, the FTSE Fledgling and the AIM (alternative investment market), which lists smaller companies not yet big enough to list on the main LSE. Other companies which created indices which are well known on the financial markets include S&P (S&P 500) and Nikkei (Nikkei 250).
Share dealing on the stock market is not a risk free investment and the share price of individual companies go up and down depending on demand, which is influenced by the company’s actual performance as well as the market’s perception of its future prospects. However, the FTSE 100 showed a gain of 4.2% between April 4th 2013 and April 4th 2014. The year from 18th July 2012 to 18th July 2014 showed a gain of 13.59% for the FTSE 100 and over the 30 years it has existed the average annual rise has been 18.3%, beating hands down any savings account.
Accessing the stockmarket through share dealing is known as ‘direct investing’, though you still always need to go through a stockbroker. When you share deal directly you buy shares in a particular company, or a selection of companies, through individual transactions.
Some stockbrokers offer advice and managed accounts, whereby you rely either partly or fully on the advice and guidance given by the stockbroker, whereas others offer execution only services so that you decide which companies you want to buy shares in and how many. In this case the stockbroker only provides the electronic platform through which you execute your trades. This form of DIY share dealing is becoming more and more popular. There are an estimated 3 million fully or hybrid DIY investors in the UK currently, a figure expected to rise to 5 million by 2017.
DIY investing does involve a degree of personal commitment as to be successful you will have to both learn how to evaluate and research a company’s performance and future prospects as well as have a general understanding of risk management and the principles behind building a balanced portfolio. The attraction of DIY investing is that you know your own aims and can put as much or little research into choosing which companies to invest in as you decide, with no one to hold responsible for your success or failure other than yourself.
Many retail investors are either unwilling or unable to make the time commitment necessary to feel comfortable with making their own picks of companies to buy shares in, or simply prefer to put their trust in experienced professionals. Investing indirectly via investment and unit trusts and funds spreads risk by providing exposure to a number of different companies. Generally speaking, the more baskets you carry your eggs in, the lower the overall risk. Indirect investing can be done via an open-ended fund such as an OEIC, Exchange Traded Funds (ETFs) or a unit trust. These investment options tend to be made up of shares from typically between 50 and 100 companies which are usually characterised by being exposed to a particular industry, geographical region or other theme such as ‘growth’ or ‘income’. They also tend to be categorised by risk level.
Money invested via such FCA-regulated fund-providers is ring-fenced so if the company defaults the money is safe. However, this does not mean the value of your investment cannot fall if the value of the shares held by the vehicle you have invested in drop.
Investment trusts are another option for pooled investment of this kind. An investment trust has the same structure as a limited company and investors buy shares from a limited issue on the stock exchange in the same way as they would buy shares in a company. The value of the individual shares in the trust will go up and down based on supply and demand for the shares, which will be driven by the value of the shares the trust holds. Investment trusts are often cheaper to buy into than funds as the investor does not pay directly for the management of the trust.
Funds and trusts are either active or passive. An actively managed fund or trust has a management team or individual who is responsible for picking the shares and their relative weighting within the vehicle’s holding. The management is responsible for adjusting the shares held in response to market movements and their predictions of how the markets will move in the future. This means that in the worst case scenario of a market crash the management should have either adjusted the fund or trust’s holdings to defend against drops in the market, or instigate damage limitation management once the market has started to drop steeply. The downside to this is that active management comes at a price and significant percentage of a fund’s returns can be eaten up by annual management fees.
These fees are also generally applicable regardless of the fund or trust’s performance, though some vehicles split fees between basic charges and performance-based charges.
Passive collective vehicles such as ETFs or other ‘tracker funds’, do not have any active management and simply track an index, such as the FTSE 100 or a more industry specific index. This means that they are generally much cheaper than actively managed vehicles. Passive ETFs are becoming more and more popular with retail investors due to their inexpensive nature and there is now a wide choice of passive tracker funds and ETFs to choose from, offering exposure to most categories of company shares you could think of. The downside to passive funds is that if the index they are tracking falls spectacularly, so will your investment.
Another option which spreads risk even further is investment in shares through a fund-of-funds or multi-manager fund. These funds invest in multiple funds, which have in turn invested in the shares of multiple companies. This makes risk management even easier in most cases and investors can choose a risk profile that suits them with the highest average degree of certainty of the investment being in line with their expectations. The downside to this kind of investment is that these types of funds generally carry the highest annual fees which can erode returns significantly.
Factors to Consider
Any retail investor considering an investment in the stockmarket should ask themselves several questions as a starting point.
• What do you want to achieve?
• Over what time period are you planning to invest?
• How much risk are you willing to take?
The most crucial thing to understand is that your appetite for reward must be considered as secondary to your tolerance of risk. Everyone wants to realise the greatest return on investment possible but there is a much greater spread of risk tolerance between individual retail investors.
Secondly, whether taking a direct, indirect, passive or active approach learn to look at the fundamentals rather than marketing materials. A company’s fundamentals such as the ratio between the value of underlying assets to the share price, company debt, expenditure plans etc. tell you what you need to know warts and all. A fund or trust’s factsheet also fulfils this function, whereas the brochure will tell you what the company wants you to see.
Comparing charges you will be subject to for both the initial transaction and ongoing admin and management costs is also important as these costs can vary hugely between both different products and the platform you use to buy them through. In most cases buying directly from a fund supermarket will be cheaper than either buying directly from the fund manager or through a bank. Retail investors must also decide whether or not they are comfortable making their own decisions or would prefer guidance from an independent financial advisor and be willing to meet the costs that entails.
It is important to realise the influence of timing. While regular transactions can eat into profits through transaction charges, depositing a single lump sum also carries the risk of losing value if the shares or fund subsequently drop in value. By drip-feeding money into the stockmarket you negate some of the risk of timing. If the market falls you will buy shares at a cheaper price the following month.
Another trap many stockmarket investors fall into is being seduced by funds or companies who have shown the greatest recent gains. This can also be a warning sign that the major gains have already been made rather than a reason to buy. However, buying shares that have recently dropped with the expectation that they are set for a rebound can also be a dangerous move as there is no guarantee that this will happen and the value of the company or fund won’t continue to fall. Investing in shares or a fund at the beginning of an upwards curve and getting out at or near the top is obviously what every investor in the stockmarket is hoping to achieve, but doing so is easier said than done.
The final key point is that investments should be held for at least five years to smooth out any bumps in the market, but that doesn't mean once they're bought they can be left unchecked. Most experts recommend keeping a general eye on your investments’ performance and conducting a fuller review every six months to ensure they are performing in line with your expectations. If they aren't, try and understand why and then look to make changes if appropriate.