Investment Choices

Investing in shares

Investing in Shares

Background

One of the most popular investments for self managed super funds, and indeed for many investors all over the world, is to buy shares in companies listed on a recognised exchange such as the Australian Stock Exchange (ASX).

So what exactly are shares ?

Shares represent a part ownership in a business. So for example, if an investor buys shares on the ASX in a well known business such as the Commonwealth Bank, the investor becomes a part owner of that business. As a part owner, the investor then “shares” in the profits of the business, and is able to cast a vote on important items at the annual general meeting. It is generally accepted that the more profitable the business is, the more valuable the shares of the business should become.

What is the share market?

By having shares, investors are able to trade their shares in that business with other investors. This is done via what is known as the “sharemarket”.

The sharemarket is the place where buyers and sellers meet to buy or sell shares, by bidding a buy price (buyers), or offering a sale price (sellers). Unlike the physical market place of years gone by, the sharemarket today is an electronic market, where buyers and sellers place orders to buy and sell shares, and can do this from virtually anywhere in the world with an internet connection via a stock broker.

Why invest in shares?

Based on history, shares are generally accepted as the asset class that has the most potential to increase investor wealth over the long term.

This is accomplished in two ways:

  1. Dividends

    If the company is making good profits, then they may distribute a certain percentage of these profits to the owners (the shareholders). These are known as dividends. In this era of ultra-low interest rates, dividends are often much higher than the interest being offered on Government bonds, cash, and term deposits. There can also be a tax credit attached to these dividends, which either acts to increase the income received or reduce the tax payable on the dividends, depending on the phase (accumulation or pension) the SMSF is in and its overall tax position.

  2. Capital growth

    As mentioned above, the more profitable the business is from year to year, the higher the likelihood that other investors will highly value the shares in that company, and hence offer higher prices to acquire them. There is also the fact that as the broad economy grows each year (although note that in some rare instances it doesn’t) this feeds into higher earnings for many businesses over time, and hence can be reflected in a rising share price over the longer term.

The risks of shares

Whilst we have alluded to the fact that shares have the potential to offer returns well in excess of risk free investments such as cash and term deposits, the flip side is that they also come with higher risk and volatility.

Risk itself can be thought of in two distinct ways.

  1. The risk of permanent capital loss (either fully or a large percentage).
    An example of this might be where an investor buys shares on the ASX in a small speculative mining exploration company. If its exploration efforts are successful, then large price gains in the stock may follow. However, if it runs out of money and goes bust, the investor is left with nothing to show for their investment, with no chance of recovery. This type of asset is what many may refer to as a “highly risky” or “speculative” asset. That is, it’s a bit of an all-or-nothing bet with very high levels of uncertainty.
  2. The volatility in the price (or value) of an investment
    Volatility is all about how much the price or value of an investment changes over a given period of time. Consider an example of where an investor again buys shares on the ASX in another mining stock, but this time it’s one of the big established mining production businesses. The prices of these highly liquid stocks change each minute of each day, based on a number of variables. This change in price, both up and down, is known as the price volatility. However given their large size, long history, strong financial position, and ongoing revenue of the businesses, the probability of these large companies going out of business in the immediate future is much lower. These are often known as “investment grade” assets, where the risk element is more to do with the fact that these daily price movements may mean that in the short (or even medium to longer term) the value of the investment may be lower than it was initially.

As a research house, Lonsec’s default position is that for the vast majority of investors, especially for SMSFs that are approaching retirement, speculative shares (such as in example 1 above) are not appropriate – or at the very least, should be kept to a very small percentage of an investor’s overall portfolio. Potential returns may be very high, but it comes with commensurately very high risk of permanent loss, with high levels of uncertainty. We tend to classify this as speculation, rather than investing, given the high level of chance that is involved in getting a positive outcome.

Direct or managed ?

Including shares in a portfolio can be accomplished in a few different ways:

  1. Direct

    The first way is to invest directly in individual shares listed on the ASX (or other international exchange). To do this, and investor will generally want to have a process around their portfolio construction, and have access to high quality research on the shares they are selecting.

  2. ETFs and LICs

    Exchange traded funds (ETFs) and Listed Investment Companies or Trusts (LICs / LITs) are vehicles listed on the ASX that enable an investor to gain access to an entire index or sector or strategy in one trade. They are a form of managed investment. See our articles in this series that explain how these work.

  3. Managed funds

    Managed share funds are another way to have an investment in shares. The investor’s money is pooled with that of other investors, and are allocated units in the fund. The fund manager invests this money on the share market on behalf of the fund investors. Just like with ETF, and LICs above, a mange fund can provide exposure to either an index, or a sector, or a particular share strategy. See our article in this series on managed funds for more information on how they work.

Using shares in a portfolio

In our “Fundamentals” section we talked about how a SMSF portfolio can be broadly split into two sections – Growth assets and Defensive assets, and that it is the weighting to each of these buckets that plays a large role in your portfolio’s potential long term return, and short term risk & volatility.

Shares are the main asset used for the “growth” assets of a portfolio. In fact, for many investors they are often the only one used, although generally in a manner that provides sufficient diversification (e.g. around 12 to 15 individual stocks or 3 or more managed investments).

Share are the asset class that will drive the growth side of the portfolio the most, and can also offer (depending on the shares selected) higher income yield than fixed income in these days of ultra-low interest rates. Of course, the flipside of this is the higher risk and short term price volatility that comes with it.

Research is crucial

As can be seen from all of the above,  shares can be good long term investments, however there is an enormous amount of choice, and they carry substantial risks for both new and experienced investors. Thus, its important for investors to fully consider each individual share on its own merits before investing.

Lonsec are experienced hands with researching shares. Our research includes a comparison table on all ASX 200 shares, with a filter to enable you to refine your universe of shares based on a range of criteria. There are also model portfolios of Lonsec’s best ideas, across small/mid cap stocks, large cap stocks, and income focused stocks.

You can also download ASX 200 Stock Viewpoint pdf reports. These are a two-page summary equity research report inclusive of a stock rating, investment risk profile, company valuation, over or under-valued analysis, business snapshot, investment view, financial forecasts, bull & bear points and key trends and charts.

We also provide a wide breadth of research on ETFs, LICs / LITs, and managed funds that invest in shares, if that is your preference.

CLICK HERE to find out more.

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