Stock Market FAQ
If you're serious about growing your savings you really have to understand how the stockmarket works and why you should consider investing in stocks and shares. Over time, cash savings accounts have been frequently outperformed by the returns generated by investing in the stockmarket.
- What are stocks and shares?
- How do I decide whether stockmarket investment is for me?
- How risky is the stockmarket and how can I minimise the risk?
- Are there any tax incentives for stockmarket investment?
- Which are the safest companies to invest in?
- Which are the most risky companies to invest in?
- Could I use a stockbroker to manage my investments?
- I only have £5000 to invest, what should I do?
What are stocks and shares?
Shares are exactly what the name implies, that is to say they are shares in the ownership of the business. As a shareholder you are a part-owner of the company and can expect to share in its profits but should also be prepared to share in its losses.
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Ordinary shares are known as equity and are the risk-sharing portion of a company's funds, as distinct from stocks, which represent long-term loans and do not necessarily confer any rights of ownership. The ordinary share holders own the company, they can vote on company policy, appoint and dismiss directors and, if the company makes a profit, they can expect to share in that profit in the form of a dividend.
Companies may issue many different types of shares and stocks and you should make sure that you understand exactly what kind of investment you are making and what kind of return you may get and in what form it will come.
How do I decide whether stockmarket investment is for me?
Sometimes it is easy to be overwhelmed by the image of the City and forget the fact that stockbrokers are really no different to anyone else buying and selling goods and services. You might prefer to think of them as pin-striped barrow boys! Remember that the primary function of a market-place for shares is actually to provide companies with a place for them to raise money to invest in their businesses.
Of course, for there to be a ready market for such new shares, there has to be a ready market for second-hand shares. Nobody is going to want to invest in something that they are not going to be able to sell when they want to do so.
The vast majority of trading on the world's equity markets is secondary trading. That is to say it is the trading of shares previously held by one or more other investor. To succeed in attracting companies, the market must also be attractive to investors.
Stockmarket investment offers you the potential for greater returns than could ordinarily be achieved by leaving your money on deposit in a bank or a building society. However, that potentially greater return comes with a concomitantly greater risk. You may feel lured into the market by the bright lights of the City and the prospect of juicy capital growth as your share prices soar and a nice income from fat dividend cheques. Just remember you can also see your investment evaporate as share prices fall and companies can cut or fail to pay dividends just as easily as they can increase them.
Broadly speaking, the higher the potential return from any investment, the greater the risk of loss. Funds committed to the stock market need to be invested for (say) between two and five years. Money that you may need back in a hurry should never go into equity investments.
How risky is the stockmarket and how can I minimise the risk?
Share investment is risk investment. That being said, by purchasing a balanced selection of shares, it is possible to limit the risk profile of your investment portfolio. Somebody approaching retirement is likely to arrange their share investments to minimize risk while a young professional may be willing to take greater risks in the hope of securing higher returns.
One basic rule of thumb suggests an inverse ratio of age to stockmarket exposure. Thus at age 30, 70% of your investments would be in the stockmarket or related collective investments but by age 65, only 35% of your investments would be equity-based. This is a very rough and ready measure that takes no account of your attitude to risk. Highly paid risk managers are highly paid to go into much greater detail (do you prefer a cautious / balanced / adventurous approach?) but it provides a starting point for you to think about your portfolio and about the kind of risks you may or may not be prepared to take with your investments and your financial future.
Analysis by Barclays Capital of the performance of different types of assets (shares, gilts, corporate bonds, index-linked and cash) shows that equities generated a real investment return of 11.4% in 2006. The next best performing asset class was cash which showed a real return of 0.4%.
Real investment returns by asset class (%pa)
|2006||10 Years||20 Years||50 Years||107 Years|
Investing in shares is not just about one year's performance. Barclays Equity Gilt Study 2007 shows over a holding period of two years, equities outperformed cash in 71 out of 106 years. That gives a percentage probability that shares will outperform deposits of 67% over a two-year period. Extend the holding period to 10 years and the probability of outperformance rises to 93%. However, you should always bear in mind that these are only statistics and returns are not guaranteed. Stockmarket investments fluctuate and can go down as well as up. Past performance is not an indication of future returns.
Reinvestment of income (dividends, interest etc,) significantly affects the performance of the various asset classes. Had your great, great grandfather invested £100 at the end of 1899 in shares and £100 in gilts this is what you would now be looking at in today's values, according to the Barclays Equity Gilt Study 2007:
Without reinvesting income
|Nominal Value||Real value|
With income reinvested gross
|Nominal Value||Real value|
These are impressive numbers but how many of us have a 106-year investment horizon? Nevertheless, your first way of reducing risk in equity investment is to be prepared to take the long-term view. The second way to avoid risk is to spread your investments. A straight forward way of doing this for a modest investor would be to purchase a collective investment, such as an investment trust or a unit trust. This could add both diversity in terms of companies in which you invest and, perhaps, a geographical spread across more than one market.
Are there any tax incentives for stockmarket investment?
Since the mid 1980s, the Government has been keen to encourage stockmarket investment. However, the incentives offered under Labour are less generous than those originally offered by previous Conservative governments. Personal Equity Plans (PEPs), introduced by the Conservatives, ensured that you could receive your dividend income free of tax and also offered an exemption from capital gains.
PEPs were replaced by Individual Savings Accounts (ISAs) by the Labour Government in 1999 with broadly similar tax breaks but lower limits on annual investments and less attractive tax benefits. As a result of changes to the taxation of company earnings, ISA and Personal Equity Plan (PEP) investment managers may no longer reclaim any tax credit on dividend income.
However, while the attraction of equity based ISAs for basic rate taxpayers is now limited to freedom from capital gains tax, higher rate taxpayers will still find investing in a stocks and shares ISA tax-efficient. The reason for this is that any dividend payments received within an ISA will not generate a tax bill for them in the way that dividend payments received outside an ISA do.
There are also other tax breaks to encourage share investment in companies on the Alternative Investment Market and unquoted companies although these tend to carry greater risks than general equity investment. These have included the Business Expansion Scheme (which is no longer available), Enterprise Zone Property Trusts, Venture Capital Trusts and Enterprise Investment Schemes (EIS).
Which are the safest companies to invest in?
The disclaimer on all investment advertisements will tell you that the past is no guide to future performance, but it does tend to be what many people rely on. Therefore, a company with a sound business track record in the past, regular profits and dividend payments and good management is likely to be a solid investment prospect. However, sometimes they are not always easy to recognise.
The biggest, most well established companies are likely to be the safest, but nothing is guaranteed and even stockmarket giants in the FTSE100 index of leading companies have been known to see their share prices plummet sharply and, sometimes, permanently.
In the stockmarket history books of the last few decades you'll find that names such as Rolls Royce, British Leyland and Polly Peck were all in the top index at the time of their demise. One of the biggest casualties in recent years was Marconi, which became a member of the 90% club. This is not an accolade but a short-hand description for that collection of share prices that lost more than 90% of their value.
Nevertheless, the bigger the company, invariably the more marketable are their shares. You should get a relatively 'steady' ride from FTSE100 companies compared to the performance of more volatile smaller company shares, but remember that all shares are about 'risk'.
Which are the most risky companies to invest in?
The most risky investments remain those companies that are new, that have never paid a dividend and that are in sectors of the economy which are as yet unproven. A small company which claims it can create electricity from recycled rubbish may turn out to be a fantastic investment, but it may equally never get off the ground.
Smaller companies are generally less well known. While this can provide big investment opportunities, it will invariably mean greater risk as smaller companies often do not have the management expertise or the capital to get themselves out of trouble if they get into it.
In recent times, promoters of stock market investment have advertised the attractions of putting money into far-off places which appear to have great growth potential. The so-called "emerging markets" have provided spectacular returns on occasions while at the same time, huge losses can be incurred.
Almost every year there has been a fantastic success story in emerging markets which has been touted by promoters. They tend to forget that each year there has also been an investment disaster area. Unfortunately, spotting which is which is, usually, something that can only be done with hindsight!
According to investment bank Goldman Sachs, within 50 years, Brazil, Russia, India and China (the BRICs economies) could be the dominant economies in the world, larger than the current six largest economies (USA, Japan, Germany, UK, France, Italy). (Source: Global Economics Paper No. 99: Dreaming with BRICs: The Path to 2050) However, getting from here to there is likely to be a bumpy and risky ride should you choose to invest in companies operating in those or other developing economies.
Could I use a stockbroker to manage my investments?
Most stockbrokers dealing in shares offer their clients three basic types of service. There is the no-frills execution-only; advisory, in which the broker will proffer advice to the client on a deal if requested; and discretionary, where the broker will manage a portfolio of shares at his own discretion on the investor's behalf in order to maximize capital growth or income, or any mix of the two, based on initial instruction from the client.
A private client stockbroker offering a full portfolio service will probably expect you to have a portfolio worth at least £100,000. That being said, some brokers will accept clients with half this amount, while others will be happy with as little as £20,000 although with such a relatively modest amount, pooled investments such as unit trusts and investment trusts are most likely to be recommended. If you have a portfolio which is towards the smaller end of these figures you should check what charges you are likely to face as they could take a big bite out of your potential returns.
Execution-only is the type of service that all online share dealing stockbrokers offer. It describes the service offered by stockbrokers where you make the buying and selling decisions on your own. Execution-only dealing over the internet has steadily gained market share over other execution-only channels (mainly telephone). Analysis by market research group Datamonitor shows that online transactions now account for 54% of all individual investors execution-only business, up from 28% in 2001. (Source: Datamonitor 23/08/06).
Online stockbroking is cheaper than traditional trading methods such as telephone share dealing, says Datamonitor. A £1000 trade over the telephone costs on average 40% more than the same trade over the Internet, while a £2500 trade costs 80% more.
I only have £5000 to invest, what should I do?
Moneyextra's own figures show that the average value of online trades in August 2007 was £3670.00 compared to £3274.00 in August 2004.
Therefore, being realistic, with only around £5,000 to invest you can only expect to buy directly into at most two or three individual shares, so with this amount available for investment in equities, it makes sense to use a unit trust or investment trust, so as to spread your risk. If you invested directly in only one or two shares you would be exposed to more risk than in a pooled investment where you may get exposure to, say, twenty shares or more.