The Armchair Trader continues its ‘Beginner’s Guide to Investing‘ today, explaining the concepts of risk, dealing with falling markets and looking at investment style – Active vs. Passive, Small Cap vs. Large Cap, Growth vs. Value investing.
If you missed the first part of the Beginner’s Guide, tackling the question ‘Should you save money or invest it?’ you can find it here.
Risk vs. Return
Before you commit your money, you must set out your investment objectives and understand what your attitude to risk is. Investments which exhibit a high expected return are bound to be riskier than safer stocks that typically earn lower rates of return. It is important to construct unique investment portfolios based on your level of risk aversion and desired investment horizon so that you have the best chance to reach your investment objectives.
It is also crucial to understand that falling markets are an inevitable part of equity investing. Stocks are heavily influenced by the wider economic landscape, which includes the level of inflation, interest rates and other economic data. This means that when the economy is stalling or contracting, the value of your investments may fall. Over the long-term, however, stock markets will generate positive returns. In the last 10 years, the value of the S&P 500 index has risen by 180% – if you had invested GBP10,000 into the S&P 500 in July 2012, your investment would now be worth GBP28,000.
The commission due and fees incurred when investing with different brokers is another crucial factor to consider before embarking upon your stock investing journey. Typically, investors will pay a fee for each transaction they make, whether that’s a purchase or a sale. Fees vary depending on your stockbroker and it’s important to consider how regularly you will trade shares, as each transaction will impact any profits you make from share price growth or dividends. Stockbrokers may also charge annual fees to offset their administrative fees.
Should you invest in stocks or funds?
Stock market investing can be performed actively, by directly investing in shares from personally selected companies, or passively through buying an investment fund that is a basket of shares managed by a professional investor.
A stock is a share in the ownership of a company. Each share will represent a claim on the company’s assets and earnings. The price of any given share will rise or fall according to the laws of supply and demand, driven by the perceived attractiveness of the company, its products and services and their subsequent performance. Ownership of a company’s shares gives you the right to receive dividends – a share of profits – if and when they are distributed.
Stocks are often defined by their company’s market capitalisation. These can be disaggregated between ‘small-cap’ stocks, referring to companies with a market capitalisation of less than USD2bn, and ‘large-cap’ stock which typically have a market capitalisation in excess of USD10bn. Smaller company shares are generally recognised as offering greater levels of potential capital growth, as profits increase and the share price rises, but also carry increased risk. Blue chip stocks are stocks of a corporation with an international reputation for quality, reliability, and the ability to operate profitably in good and bad times and often fall under the large-cap category.
Investors may also invest in stocks based on whether they are perceived to be growth stocks or value stocks. Growth stocks are shares of companies considered to have the potential to outperform the overall market in the long run due to their future potential, whereas value stocks are classified as companies that are currently trading below what they are really worth (undervalued) and will thus provide a superior return. Growth stocks typically have the potential to perform better when interest rates are falling and company earnings are rising. However, they may also be the first to be punished when the economy is cooling. Value stocks, on the other hand, may do well early in an economic recovery but are typically more likely to lag in a sustained bull market.
Rather than going through the stock selection process, some investors prefer to place their money directly in investment funds, which can be actively or passively managed. Investment funds also come in the form of investment trusts – closed ended funds in which fund managers cannot redeem or create shares.
Passively managed funds stick to a portfolio strategy determined at the outset of the fund, aiming to minimize the ongoing costs of maintaining the portfolio. Many passive funds are index funds. Although passive funds often incur very low fees and are highly transparent, they tend to exhibit lower returns. Exchange Traded Funds (ETFs) are a type of passively managed investment fund that seeks to track the performance of an index, usually a stock market index.
Active fund managers, instead, seek to outperform the market as a whole by selectively holding securities according to a dynamic and ever-changing portfolio strategy. Their investment flexibility is an attractive proposition, but it is important to note that they often have elevated fees and can exhibit higher levels of risk.
The question of which investment fund you should select is based on your own unique investment objectives and level of risk aversion. It is important to do your due diligence on a wide variety of investment funds to make sure you choose the right one that suits your long-term financial needs.
