Is It Worth Investing in Stocks and Shares? Pros and Cons
Investing in stocks and shares can be good way to make money. It's worked for a lot of people before. But does that mean it will always work? Does it mean it will work for you?
Read on for the advantages and disadvantages of stock market investing.
What Is a Stock or a Share?
A share (also called an equity or equity stock) in a company is exactly that: a share in the ownership of the company. With that comes a share of the profits and the risk that you will lose your money if the company goes bust.
Almost all companies have limited liability. This means that if you own a share and the company does go bankrupt your liability (i.e. what you owe to the creditors) is limited to the paid up value of your shares. That means that if you own share in a company that goes bust you will not lose your house because of that!
Is important to understand the ways shares can make you money. Generally shares pay a dividend to investor which is share of the companies profits. Not all companies pay dividends but instead hope to reward investors by increasing the price of the shares over time (this is called capital growth). Check the dividend policy of any company you are thinking of investing in.
In theory the price of the share should reflect the market's view of the future performance of the company and the future returns to be made out of it. In reality investors don't always behave perfectly rationally - including you.
Companies can issue different classes of shares (including for example preference shares which pay out a fixed return ahead of any other shares). But we'll focus on ordinary shares - the shares most investors will buy, sell and have in their portfolios.
Public and Private Companies' Stocks and shares
For a lot of companies the shares are not widely available. They might only be owned by one or two people and are only sold very rarely. These are called private companies.
Other companies have their shares traded on stock exchanges (also known as stock markets) such as the New York Stock Exchange or the London Stock Exchange. In order to be listed on these markets the companies will usually have to follow a set of stricter rules than a private company. These companies are known as public or listed companies.
It is relatively easy to trade in listed companies—your stockbroker can trade them for you. It is more complicated to buy and sell private company shares: this is generally left to private equity funds and wealthy individuals who can afford specialist advice.
Investing in Stocks and Shares - the Pros
The advantages on investing in shares include:
1. Capital growth - generally the price of stocks and shares goes up on average over time so your portfolio will be worth more in the future
2. Higher returns that bonds or cash deposits on average - because equities (stocks and shares) go up and down in value more than bonds or cash deposits the market pays a higher return to "compensate" you for this on average. This does not guarantee that you will always have a higher return in shares compared to bonds!
3. Some protection against inflation - if there is inflation corporate profits should increase in cash terms at least (ignoring inflation) so dividends and share prices should go up. However there is no direct link to inflation so the protection is not perfect.
4. Ownership and influence over companies - you may have a say via the company AGM in the company policies and get a vote on shareholder issues. This will generally only apply if you own stocks directly. If you have invested in a mutual fund or a managed fund or other collective vehicle you can always lobby your investment manager to vote according to your views but they will have thousands of people invested in their fund - so your opinion may not carry too much weight.
Investing in Stocks and Shares - the Cons
The disadvantages of investing in equities (stocks and shares) include
1. The risk that the company will become bankrupt and your shares in that company will be worthless. This is why diversification is important - see below.
2. The risk that the price of your shares will fall when you want to sell them so that you get back less than you paid for them.
3. There often high charges for managed funds and mutual funds which invest in equities. Shop around to make sure you get a good deal.
4. Returns are unknown so it can be hard to plan you finances in advance.
Diversification means owning lots of different stocks and shares so that if one or two of them are wiped out and lose all their value your portfolio of investments will not be completely gone.
It is generally accepted that a diversified portfolio can get the same average returns as a non-diversifed one, but with lower risks. Basically you should always diversify. Never put all your eggs in one basket.
For small investors that means that investing via a mutual fund or a managed fund or even an exchange traded fund can be an attractive option. These products are funds that invest in lots of different share so give you diversification without the costs of buying lots of shares directly yourself. Obviously they will charge management fees so you should weigh up whether they are worth it for your situation.
Active funds are those where the manager tries to beat the market by picking stocks. These generally charge more, but can outperform the market (but can also do worse than the market). Passive funds just try to keep up with the market as a whole. These tend to be cheaper (ie lower fees) as they require less management.
You should generally speaking diversify within an "asset class", i.e. buy a range of shares, not just in one or two companies.
It's important to diversify your investments into different kinds of assets as well. There are lots of other "asset classes" to consider investing in: for example, corporate bonds, commercial real estate, and gold.
Stocks and Shares Compared With Other Assets
The shares I have been talking about in this article are "common stock" or "ordinary shares", rather than preference shares or any other kind of special share.
You could also invest in the debt of the company, rather than investing in its equity through stocks or shares. That would mean investing in corporate bonds. For most investors this has to be done via funds as the individual bond sizes (tyically $10,000 or larger) are too big for most retail investors.
Investing in stocks and shares can be rewarding, both personally and financially but it does involve risks. You have to take the rough with the smooth. You should invest for the long term and not use money you will need to live on in the near future.
Do your research properly (there is a lot of information out there) and understand the possible risks and rewards. Find a strategy or a plan that works for you in your situation and that you are happy with come rain or shine.