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How to Invest in Shares & The Stock Market

This is Financial Expert’s official article on how to invest in shares and how to invest in the stock market. Investing in shares is a colossal topic, so we have created this hub page, which will guide readers to other content and articles that they find helpful. If you want to think of this as ‘investing in shares for beginners‘, that’s fine although you will find many intermediate and advanced topics through these pages as well. You may also be interested in ‘How to Invest in Commodities‘.

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Contents

  1. What are Stocks & Shares
    1. Why are Stocks & Shares so Popular?
    2. Are Shares & the Stock Market Suitable for Me?
  2. How Many Stocks & Shares Should I Invest In?
    1. Introduction to Diversification – Free Insurance
    2. Diversification Means Higher Returns
    3. Introduction to Funds
    4. Index Funds and ETFs
  3. How to Pick a Share / Stock
    1. Financial Websites
    2. Using Financial Ratios
    3. Value v Profitability
    4. Financial Advisors
  4. How to Execute a Trade
    1. Are all Stockbrokers the Same?
    2. How to Choose a Discount Broker
    3. Introduction to Ticker Symbols
    4. Trading by Phone
    5. Trading via Online Platform
  5. Administration & Paperwork
    1. Retain Records for Tax Purposes
  6. Selling Shares / Stocks
    1. Psychological Traps
    2. Tax Considerations
    3. Reinvestment

1. What Are Stocks & Shares?

‘Stocks and shares’ actually both mean the same thing, so I will refer to them as ‘shares’ from this point onwards. A share gives its registered owner fractional ownership over a company. A share entitles them to the assets of the business, as well as a share of the profits distributed in the form of what is called a ‘dividend’. A share also grants its owner a vote to use at the Annual General Meeting (AGM). While all ‘Ltd’ or ‘Plc’ companies have shares, the public can only easily invest in companies that are ‘listed’, which means their shares are priced and traded on a stock exchange.

1.1 Why are Stocks & Shares so Popular?

Shares are popular with investors for two main reasons: high expected returns, and liquidity. Over the past century, shares on average have produced a 9% annual return. Investments in bonds and real estate have not performed as favourably, which has given the share the number one spot. Secondly, shares can be bought and sold within 10 seconds on a computer, which makes them incredibly flexible and suitable to a wider range of investors, some of whom may want to be able to move their money between different investments quickly. To read more about the popularity of shares and the 6 different reasons I identify to explain why shares are so popular, read ‘Why are Stocks & Shares a Good Investment?‘.

1.2 Are Shares & the Stock Market Suitable for Me?

Financial Expert is not authorised to give professional advice, so while we hope you gain a lot of information and sound investing knowledge from this page, we cannot specifically promise that shares are an appropriate investment for you. We do not say this to be erring on the side of caution, but because it is our legal responsibility to not provide individualised professional investment advice. Such advice can only be given by an authorised financial advisor. See ‘Do I Need a Financial Advisor?

As a rough guide, shares are appropriate for investors who can invest and commit capital for the long term. This means 7-10 years or more. The longer the period of investment, the higher the probability of a positive return and the lower risk will be. Risk can sometimes be measured by the ‘standard deviation’ of returns (which measures by how greatly returns vary year on year), this graph and this graph shows how the risk of shares reduces dramatically when an investor holds them for the long term. Suitability is also dependent on other factors, such as risk tolerance and whether you have debts to pay down.

2. How Many Stocks & Shares Should I Invest In?

The question of ‘how many shares should I pick?‘ is actually more important than ‘which share should I pick?‘. This is because nobody can say for certain or with likelihood that Share A will outperform Share B. If this were the case, many investors would see Share A as cheap and a great buying opportunity. As a result of all the buying, Share A will increase in price extremely quickly until investors were no longer sure that Share A would outperform Share B. This is a strong principle that underpins the markets, and ensures that prices reflect the market’s opinion of performance. As a result, in theory every share has an equal chance of out performing the market, as it has of under performing the market.

For an investor to ‘beat the market’, they would have to be in possession of information or analysis that the market knew not. While this is a possibility within investment banks and hedge funds, it is unlikely such information would fall into the lap of you or I. Therefore I hope you will see that expecting to pick stocks that perform better than average is an unrealistic assumption, and is a common mistake made by new investors.

2.1 Introduction to Diversification – Free Insurance

Whilst an investor cannot expect to beat the market consistently, there is one approved tool that investors can use to almost guarantee that they will achieve higher returns than without. This tool is the simple science of diversification. You will be familiar with the phrase ‘don’t put all your eggs in one basket’. This phrase was practically invented for the stock market. Diversification helps your portfolio (yes, you can call it that from now on!) in 2 different ways.

Firstly, diversification reduces the risk of heavy losses – without cost. I want you to think of diversification as the cheapest insurance policy you’ll ever buy. When you own shares in just one company, if that company were to go bankrupt you would lose all of your investment. Let’s assume that the probability of a company going bankrupt in a given year is 2%. Holding one company’s shares means you have a 2% chance of losing all your money each year. That’s a scary thought. Now let’s pretend you hold shares equally in 5 unrelated companies. The probability of each one going bankrupt is still 2%. For you to lose all your money in a given year, all 5 would need to go bankrupt with a probability of 2% each. The chance of that occuring is absolutely tiny at 0.02^5 = a one in three billionths chance.

Diversification doesn’t just protect you from potential bankruptcy – but all unexpected events that could happen to a company (good or bad) including failed product launches, oil spills, scandals and so on. Shares are expected to return 9% per year, but these individual events that pop up during the year will skew that return and cause each company to either overshoot or undershoot. Diversifying across 5, 20, 100 or even 1000 companies will help to smooth those bumps out, so that overall your portfolio returns a much more consistent figure each year. The only events that can affect a diversified portfolio are those events which effect all companies, for example economic woes, government policy and large scale environmental disaster. So in short, diversification will help smooth your returns for free and therefore let you sleep easier at night! The minimum number of shares still considered reasonably diversified is 20, although 100 is better!

2.2 Diversification Means Higher Returns

If you remember, I actually said there were 2 other ways in which diversification will help you. The second effect is that your returns will actually increase! This is a purely maths based fact, but a loss will affect your portfolio more than an equivilent gain. Why? Well because if you make a 60% loss, then you actually need to make a 150% gain next year to get back up from 40 to 100! A 60% loss requires a 150% gain to break even. Here’s another way of thinking about it – If you suffer a 95% loss one year, that’s pretty much game over. You can’t recover from 5 to 100 within a sensible timeframe at all, it would require a 2000% gain in the following year. But if it went the other way and you had a 95% gain, all you’ve done is double your money, a relatively insignificant reward against that game-ending loss. If you played a game whereby you flipped a coin, and heads gave you a 95% gain, and tails gave you a 95% loss, how many rounds do you think you’d survive? You would lose almost all of your money in just a handful of rounds, despite a 95% gain and 95% loss appearing (if only at first) to cancel out.

Why am I saying this? Well I’m trying to show you that volatility isn’t your friend in any shape or form. Which investment would you prefer – an investment that pays you a fixed 10% return every year, or an investment that provides you with an average return of 20%, by paying out 70% then -30%, 70% then -30% and so on? The answer is you’d prefer the 10% per year. After 6 years you would have £177 for £100 invested. In the second investment with the higher ‘average’ return, you would only have £168.50. This is due to the extra weight that losses carry. Diversified portfolios provide a smoother return, and a smoother return means fewer losses, which results in you keeping much more of your money!

2.3 Introduction to Funds

Eventually an investor realises that rather than trying to beat the market return by picking a few shares, it would be more efficient and less stressful to simply invest in every share on the market. There will be some shares that nose dive, but there will also be runaway successes, and all of these would cancel each other out to hopefully produce the 9% average return per year that we have observed since 1927. The next question the investor asks is, ‘How can I invest in every shares in the market without having to make 1,000s of trades and pay stockbrokers a fortune in commission? The answer comes in the form of Mutual Funds and Index Funds. Mutual funds are popular but flawed. Since existance, mutual fund managers have performed fairly well, but charge high fees for managing funds, such that the average mutual fund does not beat the market after fees.

If the average actively managed mutual fund fails to beat the market, then what is the point of investing in them? My point exactly. Read more on the debate between Passive Investing v Active Management. Many say that the explosion in so-called ‘free’ financial advisors has encouraged the selling of expensive funds, due to the fact that these offer advisors the most commission. It’s a depressing explanation but it’s probably the most accurate. For more information on the independence of financial advisors, read ‘What Types of Financial Advisors Are There?

2.4 Index Funds and ETFs

However there is no reason to be gloomy because the answer to investors’ frustrations arrived in the 1980s in the form of passively managed index funds. Index funds carry much smaller fees due to their almost automated management and smaller salesforces. Rather than trying to pick great shares index funds invest in all the shares that make up a particular index, and it is then said to ‘track’ that index. An example of an index is the FTSE100 or S&P500. These are composed of the prices of many different shares, and help investors to see how the markets are performing overall. Some index funds are very broad, such as the iShares MSCI World ETF, whilst some are very narrow such as the iShares MSCI Japan SmallCap ETF which only invests in smaller listed Japanese shares.

You may notice that both of these funds are called ‘ETFs’. ETFs are special type of fund, that can be bought and sold on a stock exchange just like how we invest in shares. In contrast, a standard ‘index fund’ works like a mutual fund, whereby you join them almost like a bank, and register and deposit funds etc. ETFs are different in that you just buy them like a share through your broker, and they sit in your portfolio just like a share! ETFs have broad popular support from small investors that want a diverse portfolio which is easy to manage.

Remember, diversification is about spreading risks and investing in shares that are not effected by similar events. Because of this, simply buying an ETF that invests in 20 UK retail companies is not good practise. Ideally you want to spread your money across all sectors, all geographic regions and all sizes of companies. This is achievable with about 5-6 carefuly selected ETFs. Who said investing in the stock market would be difficult?

3. How to Pick a Share / Stock

There are 4 elements of company analysis that a beginner should take into account when picking a share to invest in. These are stewardship, fundamental analysis, technical analysis & dividend policy

Stewardship is an assessment of how effectively the management team have run the company. Famous investors such as Warren Buffet cite responsible management as one of their key factors in their investment decision.

Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. Basically it involves looking at the big picture and analysing the prospects for a share. Investors who invest in the stockmarket using a fundamental framework look to find trends and links in information, and use this to form an expectation of which shares will be advantageous.

Studying price charts and deciding to invest in shares based soley on the graphs would make you a ‘technical analyst’. Technical analysts believe that all known information is reflected in the price, and therefore there is no need to study fundamentals separately. Technical analysis is a highly complex and difficult topic, and is out of the remit of this introduction to how to invest in shares. However you should know that technical analysts believe that shares move in short term and long term trends, and look to spot changes in trends as soon as they occur.

Dividend policy dictates what a company does with its profits. Large and established companies like BP and Marks & Spencer pay dividends each year, whilst growing technology companies like Google retain all their profits and reinvest it in the business. Dividend policy does not affect your shareholder return. If a company pays out profits you will receive it as income, if the company retains profits you will experience a capital gain on your shares. But you may have a preference for receiving income or receiving capital gains depending on your tax and financial circumstances.

3.1 Financial Websites

You can gain access to reams of financial information on finance portals such as Yahoo Finance and Google Finance. Both provide delayed (and sometimes live) prices of shares, along with charts, accounting data and divdent information. They are a great place to begin researching companies or ETFs. I would recommend that you stay away from ‘opinion’ websites that provide trading ideas or opinionated comment on the weeks market news. Financial news analysis and opinion are good for educational purposes but they are not ideal to base a share purchase on. For each share, you will quickly be able to find an experienced investor who is bullish (positive) about prospects, and one who is bearish (negative) about the future. If you trade off persuasive opinion articles then you may not be hearing the other side of the story.

We started this section with the cleanest and purest of financial websites, but now I want to finish by issuing a warning about dangerous financial websites. Websites you should avoid at all costs are ‘stock picking’ newsletters, ‘penny stock’ or ‘hot stock’ watch list or any form of ‘proven system’ that promises to deliver exceptional returns. These are at best useless, and at worst fraudulent.

For our ultimate guide on finding free financial information to guide your decisions, read ‘How to Find Financial Data Online (For Free)

3.2 Using Financial Ratios

As part of fundamental analysis, you may want to calculate a few financial ‘ratios’ to get a picture of a companies financial position relative to its competitors. An example of a ratio is ‘Net Profit Margin’ which you calculate by dividing net profit by sales. This ratio tells you how much profit a company makes as a fraction of its revenue. If you compare this against competitors, the net profit margin will show you which company is operating more efficiently. Other useful financial ratios include gearing, current ratio, interest cover and return on assets. Do a bit of research and find out how to calculate these. Alternatively you can find out many ratios on the financial websites discussed above.

3.3 Value versus Profitability

You’ll remember from section 2 above, that if the market senses a share on the stock market is underpriced – traders will quickly act to gobble up any bargains and bring the price in line with perceived values. This highlights one of the problems you will run into when deciding whether to buy a share. You may do the research and find a fantastic company with excellent growth prospects – but at £12.43 per share, how do you know whether this represents a good buy or not?

3.4 Financial Advisors

If you’ve researched many shares and ETFs but don’t feel comfortable making a call, seek the help of a financial advisor. A financial advisor doesn’t have to completely take the reigns and invest your portfolio for you, it can be a very collaborative process. You may want to use a hybrid method, whereby you create an investment plan and pay a financial advisor, such as Fisher Investments Firm, to comment on whether your plan reasonably matches your objectives. I have asked a firm for a quote on such a service, and they quoted me £300 for the meeting, so I can recommend this to you knowing that it needn’t be expensive for medium sized portfolios. Read our article on ‘What Types of Financial Advisor Are There?‘ and ‘Do You Need a Financial Advisor?‘ to assess whether you should seek professional assistance.

4 How to Execute a Trade

The main system used for share trading on exchanges in the UK is CREST, which handles electronic ownership of share certificates. Electronic and recently online trading has become the #1 way UK investors buy and sell shares and consequently the ‘nominee account’ has become the most popular way to hold shares. When you set up a nominee account with a brokerage firm, you give them permission to hold the shares in your name. This means that the brokerage firm appears on the central share register rather than your name. The shares are still legally yours and do not form part of the brokerage’s assets, but holding in nominee allows for their transfer to be processed extremely quickly.

In the past, the public held share certificates and were personally named on the share register, which entitled them to special discounts from the companies they owned. The rise of impersonal nominee accounts where you are effectively just a ‘number’ to the company, perks have begun to disappear for shareholders.

4.1 Are all Stockbrokers the Same?

Stockbrokers can be very different businesses to deal with. There are two distinct types of stockbroker: Full Service Brokerages & Discount Brokerages.

Full service brokers will execute trades for you, but they will also give you tips and advice. Full service brokers may be proactive in calling up their clients when their research identifies an underpriced share, or a strong sell signal. If you have the desire to purchase Google shares but aren’t so sure, you could even ask your broker for their opinion on their shares. Full service firms have a strong incentive to generate lots of trading ideas an ‘sell’ these to their customer to generate trading fees. Short term compensation plans for brokers also don’t encourage quality but quantity. This ‘full service’ naturally comes at a very ‘full price’. It can often cost £200 to execute a trade through a brokerage firm, and there are additional fees such as annual retainer fees which further eat away at your capital. Full service brokers are almost universally frowned upon by the online investing community.

Discount brokers offer the lower cost methods of buying shares. For as little as £10 you can execute a trade using an online platform. Discount broker execution is simple and can be as easy as sending an email, however great care must be taken as there is a higher risk of error than with full service brokers. If you accidentally buy the wrong investment, for example if you enter the ticker symbol incorrectly and failed to review the summary window, then the fault is your own, and you would not be entitled to any compensation from the broker. On the other hand if a full service broker executed a trade incorrectly, you would be entitled to claim against them for any losses incurred.

4.2 How to Choose a Discount Broker

In choosing a discount broker, you firstly want to look for accounts that carry low or nil annual management charges. Share investing is a long term business, so you don’t want to choose an account that will charge you £25 per quarter for being inactive. Secondly the trading commissions are an important factor. Discount brokers will usually offer discounts to ‘frequent’ traders who trade more than 15 times per quarter. Don’t be influenced by these rates if you only plan on buying a handful of ETFs and holding on to them – look at the standard commission. £12.50 or lower is reasonable in the UK market £20 for an online trade is expensive. Finally you’ll want to check that the account comes with all the bells and whistles you’d expect, including telephone support, telephone trades (for emergencies) and research tools. If you want to invest tax-free then ensure the broker offers a competitive Stocks & Shares ISA. ISAs usually come with extra annual management charges, but I can personally recommend (my account) the TD Waterhouse Trading ISA which as of writing, has no annual charges provided you keep it funded above a minimum threshold, although T&Cs may change.

Discount brokers can levy heavy exit fees for closing your account and transfering shares to another broker. These exit fees are an industry standard so don’t expect to be able to escape from them! Fees of £20 per holding plus a £30 closure fee is typical. If you’re used to free savings accounts and current accounts, this may come as a shock. Exit fees crank up the pressure on you to choose the discount broker that is right for you, so shop around and make your first decision your best decision.

4.3 Introduction to Ticker Symbols

The ticker symbol is a group of letters e.g. GOOG that represent a particular traded share on the stock market. When you want to research or place a trade, you can use the ticker symbol to instantly find the share you’re after. You can find the ticker symbol of a company by searching by name on Google Finance or Yahoo Finance. If I search for ‘Land Securities’ on Google Finance, the title of the company page says “Public, LON:LAND” which shows that the ticker symbol is LAND and it is traded in London. Some ticker symbols are just on letter ( F – Ford Motor Company) whilst others contain 4 characters, and some even include extra information after a dot. For instance when a company issues more than one class of shares (where one class has more rights over another) these will be referred to as ‘A Class’ and ‘B Class’ shares, and the ticker may become LAND.A or LAND.B to distinguish between them. So always do your research and make sure you’re using the correct ticker.

4.4 Trading by Phone

Discount brokers also offer the opportunity to enter a trade over the phone with a human, for an increased fee. If the online trading commission is £12.50, then the telephone trading fee will be roughly £20. Being a discount broker, the representative on the telephone cannot offer you any advice whatsoever, and merely fills in a similar order form to the one you would have completed yourself online. If you ask a telephone broker to buy ordinary shares in Marks & Spencer, they will know exactly which ticker symbol to use, which makes telephone trades useful if you’re having difficulty ascertaining whether you have the right ticker symbol for the type of share you want.

4.5 Trading via Online Platform

Whilst different user interfaces will work differently, the information you have to provide to a discount broker to trade will be exactly the same. To see a step by step walkthrough showing how to buy shares with my broker, see ‘How to Place a Trade‘.

5 Administration & Paperwork

Setting up a brokerage account is similar to a bank account, and within a week or so you will receive plenty of welcome leaflets and statements through your door. The important information to keep are records of trades and any interest earnt on cash in your account over the tax year.

5.1 Retaining Records for Tax Purposes

The primary reason for good record keeping is for tax purposes. If you have a Stocks & Shares ISA, then all returns you experience in the account do not even need to be declared, which simplifies the process considerably. However if you trade in a standard account, you will need to declare both dividend income and capital gains. A capital gain is only realised when you sell shares, not simply when your portfolio rises and falls. For the 2011/2012 tax year, taxable capital gains are those over the threshold of £10,600, and will be taxed at different rates depending on your income. For one-off sales, capital gains are easy to calculate. However if you’ve been drip feeding funds into a share each month through a regular investment plan – the calculation will be nothing short of a nightmare.

6 Selling Shares / Stocks

Executing a sale of shares is just as simple as purchasing them, with the only different being that you select ‘buy’ instead of ‘sell’. Timing the sale of shares is an altogether trickier problem.

6.1 Psychological Traps

When investors learn how to invest in share or the stock market, a lot of attention is paid to picking shares and funds but less is paid to the eventual sale of these investments. Investors a prone to falling into several psychological traps when it comes to timing a sale. Firstly, emotion plays a large part in peoples decisions when investing in shares should actually be an objective game. Selling in fear is one of the largest causes of losses to investors, as shares usually become oversold when panic hits the financial markets. Emotional trading causes bubbles to form and crashes to take place.

A common problem with retail investors is that they hold onto their loss making shares and sell their profitable ones. The justification for holding onto losers is the chance to redeem ones poor decisions and ‘break even’. This is remarkably similar to problems afflicting serial gamblers trying to gamble their way out of a losing streak. When you make a judgement with all the facts and figures behind you, which eventually turned out to be a bad call, it is common to feel disapointed and embarassed, but this should not hinder you from selling your shares and turning a ‘paper loss’ into a cash loss.

Indeed my best advice for selling shares is that you shouldn’t be focusing on the gain or loss at all. The price you paid for a share should not have an impact on the timing of the sale. In an ideal world, the correct reasons for selling shares are a change in investment strategy, the rearranging of a portfolio to manage risk, or exiting from a share that now appears overpriced. Therefore if a bank has issued bad results and the price has nose dived, you should only sell if you believe that the current price overvalues the bank. If the prices have already fallen by 20% such that you believe the price now reflects the actual prospects for the bank, then there is no logical reason for a sale.

6.2 Tax Considerations

While tax advantages should never be the primary reason for making a particular type of investment, the beginner should seek to minimise tax liabilities where possible at minimal cost. In the UK this typically includes opening a Stocks & Shares ISA. For purchases made outside of an ISA, an investors should look for companies and funds that have a dividend policy that suits their tax situation. (High tax earners would prefer capital gains to income tax, so they would prefer companies that pay no dividends). Shares should also me timed efficiently so as to not incur capital gains tax where possible. This could include selling a portion of shares one year, and the remainder in the next tax year to make full use of the CGT threshold. However please be aware that the tax regime can change at short notice.

6.3 Reinvestment

As is highlighted clearly in our article ‘How to Retire at 50‘, compounding is a tremendous force in the growth of your portfolio. Make sure you reinvest your dividends and proceeds from share sales whereever possible, to accelarate the growth of your portfolio. Discount brokers usually offer a ‘dividend reinvestment’ service for UK shares, whereby they will automatically reinvest any dividends received in a company back into their shares. Brokers often charge a very small commission for such transactions, so that fees usually form no more than 2% of the amount reinvested. This is a smart and efficient way to get the full effect of compounding.

We hope you have found this guide on how to invest in shares and the stock market helpful. Investing in shares is such a large area that we can’t hope to cover every angle and every question you may have, but if you do have any queries, add them below in a comment and we will try to update the guide or write a new article to answer your question. Good luck investing!

 

Simon OatesHow to Invest in Shares & The Stock Market