Individuals who want to invest in equities need to understand the risks associated with investing. Investing in shares can be highly lucrative and can set you up for a bright financial future. However, understanding the risks and benefits associated with buying shares is a crucial step for your education.
Investing in shares, like any investment, comes with a certain amount of risk. Shares are often described as ‘high-risk asset classes’ when compared with other types of investments. The primary risk of investing in shares is that it can result in loss of capital. Unexpected events outside of your control or negative developments within the company can significantly affect share prices and the value of your portfolio. In saying that, this is not to scare you away from investing in shares, but merely a necessary understanding that all investors must have.
There are ways to reduce the risk associated with investing in shares. The following are common measures that investors should have in place to control the risks associated with buying shares. Keep in mind that this is general advice only and may not be suitable for your personal circumstances.
Not having all your eggs in one basket is a motto that strongly applies when it comes to buying shares. Probably the worst mistake a new investor can make is to not diversify adequately. Diversification refers to making sure an investor has shares in several companies of different industries/sectors/countries etc, thereby reducing the risk relative to the return. The degree of diversification is to the discretion of the investor. For example, if you decide to invest your entire portfolio in a single company dominated by the oil price, a collapse of the oil price will result in a collapse of your entire investment. Hence why it is important to diversify across different industries. Diversification on the share market can take many forms, for example investing in different sectors or different countries or both. For example, a well-diversified portfolio may have exposure to Telecommunications, Materials, Financials, Consumer Staples, Information Technology, and International, just to name a few. The difficult part is knowing which sectors are most suitable and more importantly which companies within the sector are suited to your investment goals. One of the problems that often arise with diversification is that investors diversify at the cost of understanding their investments. Diversification is an important step when building your own portfolio.
It is vitally important to understand the company you are buying a share of. These days many investors forget that when they buy a share they are actually buying a part of a business and not just a digital ticker code. Without fully understanding the company’s operations, its financials or future outlook it is very hard to determine if it will be a good investment. The problem arises when you are interested in a firm, however you are unable to fully understand its business model. In order to diversify adequately, you may be forced to look outside your scope of understanding. If you don’t have the time or expertise on how to analyse companies a finance professional may come in useful. Having a professional equity analyst to contact and discuss the company will potentially lead to better investment decisions.
Different strategies can lead to success, however in Wise-owl’s view investors have the greatest chance to succeed in the stock market by taking on a long-term approach. An investor’s holding period (how long the investor plans to hold the shares) is crucial when it comes to investing. The shorter the investment horizon, the harder it is to predict the direction of the stock. Market fluctuations are regular, mostly unprovoked and are hard to predict. A common mistake among investors is to sell after a fall and buy after a rise. This results in complete absorption of the fall and missing out on the rise. The rule of thumb is don’t try and time the markets, have long term outlook and invest in good companies.
Emotions are likely the number one challenge investors face on a day to day basis. Media speculation, your Barber’s stock tips, fear of missing out or running with the crowd are all factors that affect our emotions and in turn our investment decisions. Removing emotion from your investment decisions is easier said than done however having an investment strategy and the discipline to stick to it, can reduce the risk of emotional decision making.
Now that we have spoken about the risks associated with investing and how to reduce it, we will analyse the benefits of investing. There are several reasons as to why an individual chooses to invest in the stock market. There is hardly any other investment vehicle which facilitates such a diverse set of objectives like the equity market. The stock market facilitates investors from all geographies and all investment styles. The following is just some of the main benefits from investing in shares:
Over the long term shares have outperformed every other investment vehicle including property, bonds, cash and several others. We emphasise that this is over the long run as shares do fluctuate more than most other investment vehicles. if you are unlucky with your timing or stock pick you might not outperform, however in the history of the stock market shares have increased in value despite several bear markets or ‘market crashes’.
Some shares also provide income by the way of dividends. Dividends are the shareholder’s portion of the company’s un-retained earnings. Dividends are generally paid by larger corporations with an established income profile and years of reliable earnings. Most companies pay out a certain percentage of their earnings through dividends, which means that the net payout will grow if earnings grow. Dividends can be received in cash, by cheque, or be reinvested in the company, also known as a ‘Dividend Reinvestment Plan.’
Shares are more liquid than other investment vehicles. When we refer to liquidity we basically make reference to how easily an investor can find a buyer or seller for a transaction. The largest companies listed on the respective stock exchange offer the average investor with enough liquidity to buy and sell shares instantly. This provides investors with the flexibility to use their funds where they see fit. It is important to remember that transactions are subject to brokerage fees and need to be incorporated into your calculations. Smaller companies also known as small-capitalisation stocks may not offer enough liquidity to allow instant transactions on a daily basis.
Stock markets provide investors the opportunity to gain exposure to several sectors and markets. For example a young couple with their entire savings invested in property will only have exposure to the property market. If the property market declines, the young couple will be fully exposed to the decline. Whereas a young couple with a diversified share portfolio can have exposure to several sectors and markets and can therefore reduce the impact of a sector specific risk.
The most important point to remember is that there is no secret to successful investing. The only rule is to buy great companies and buy them at the right price. This has over time been a proven way to achieve success on the stock market. Being aware of the risks and rewards of investing in the stock market is crucial for the decision making process. There are basic principles that allow you to minimise the risk of investing as outlined above, however, there is no way to completely remove risk.