Why Are Stocks & Shares a Good Investment?

On the ultimate guide of ‘How to Invest in Shares & the Stock Market‘ we briefly addressed why shares are so popular as investments. This article will expand upon those reasons.

Expected Returns

The average historical return of shares often quoted by the financial media & providers is roughly 9% per annum. This is a nominal return (i.e. it does not reflect inflation, the concept that £109 will not be able to buy as much in 1 years time as it does now). Real returns are a few percent lower, depending on which inflation measure you use over which time period. While advisors, actuaries, media and salesmen generally assume that such a long term average will continue in the future – this assumption is after all just an assumption. This opinionated article by legendary fund manager John Bogle, writing for the Financial Times, questions the validity of this assumption of return.

Despite criticism of this figure, it is widely regarded and used to compare the returns of equities (shares) with other asset classes, such as bonds, cash, real estate and private equity. This comparison reflects on stocks & shares very favourably, as bonds & cash have returned far lower in the past, and private equity is perceived as riskier and much more volatile. As such, shares have become an investment that feature prominently in portfolios that seek a good return.

Tax Flexibility

Shares offer investors the choice to pick micro-investments that distribute profits in a way that suits the investors trying to minimise tax liabilities. In the UK, the capital gains tax (28%) paid by high earners is far lower than the higher rate (40%) and additional higher rate (50%) they would be paying on income. Therefore investing in shares allows them to handpick companies that ‘capitalise’ their profits, or in others words they retain and reinvest the profit in the business. Conversely, lower earners such as pensioners can invest in high dividend companies or unit trusts which distribute profits as dividends which are taxed at 20% or less.

Tax rates and rules are subject to change, so I encourage you to research your own situation as the tax regime is far more complex than the simplified examples above imply.

High Volume

Shares in large (‘Large Cap’ or ‘Blue Chip’) companies are traded extremely heavily throughout the trading day. This means that we can say the market is very ‘liquid’, which means it is very easy to obtain a fair price for your shares instantly. For less liquid investments such as the corporate debt issued by small companies, trading may not be instantaneous, and may cause the market price to move against you as you try to make a trade. This is because the market participants will have a more difficult time finding buyers and sellers, and may have to offer a more attractive price to the other party to stimulate interest if trading volumes are low.

As well as being able to buy & sell shares at a fair value instantaneously, high volume also means you pay smaller costs as a result of the ‘bid/offer spread’.

Quick financial markets lesson:

In every market there are two separate prices – one is the price you can buy at (higher) and one is the price you can sell at (lower). This difference between the buy and sell price is the bid/offer spread. For large companies, this spread may only be a penny or less per share, and is barely noticeable.

However in markets for lower volume investments, financial firms setup business and agree to always buy off investors, and sell to investors on demand. They act like a simple flea market trader, offering a slightly lower price to buy investments off investors, and sell them on for a slightly higher price. Competition between rival firms ensures that prices are reasonable. These firms allow the market to function properly, and hence they are called ‘market makers’.

Market makers are not speculators, so they try to keep as little stock on their books at all times, and aim to balance demand and supply for the given investment. They do this through changing prices. If demand falls, then market makers reduce their bid & offer prices to encourage more investors to begin buying. This is one way in which the preferences and information of investors actually moves prices. If a market is especially illiquid, then market makers will have no choice but to ‘stock up’ on the given investment in the hope that sellers will emerge later. Imagine a market makers’ bid offer prices are £10 to buy off and £10.20 to sell to, there is a risk that they buy a big block of investments at £10 but later have to reduce their sell prices to £9.80 to make a trade. In this instance, the market maker has made a loss! To reduce the risk of this happening, market makers widen their bid/offer spread in lower volume markets, to help ensure that short term price fluctuations don’t wipe out their margin. This can have a substantial effect on investors returns. In some illiquid markets, the bid/offer spreads are sometimes 5%, which means investors make a 5% loss as soon as they purchase.

Now if I bring you back to the main topic of this article,  you can now understand fully why the high volume trading in shares is attractive to investors. It allows them to sell instantly, get a good price AND pay a lower bid/offer spread.

Regulated

Recognised stock exchanges such as the London Stock Exchange, New York Stock Exchange and Tokyo Stock Exchange are heavily regulated, which implies that the conduct of market participants and the conduct of investment providers is better than for other types of investments. Regulators like the UK Listing Authority

Heavy Analysis – Efficient Pricing

The large companies listed on the main exchanges are heavily scrutinised by analysts, journalists, fund managers and regulators. This helps disseminate information about the company and its prospects as efficiently as possible. Assuming rational investors, this means that the prices of these companies should be as ‘efficient’ or ‘close to actual value’ as is possible. Even if a fund manager chooses to keep their research close to their chest – their trades will impact the market price and push the share price in the direction it needs to be. For example if a hedge fund manager learns of a potential fraud that has occured at Coca Cola, they will sell their shares in the company, which will push the price down – closer to the value it would be if all information was public. Because of this, the heavy interest in public companies ensures they are priced reasonably. This is a fairly academic topic and the efficiency of markets is widely debated. What is clear however, is that the heavy analysis ensures that relatively speaking, equity markets should be more efficient than most other investments.

Loyalty & Novelty

Finally, I would be foolish to forget that shares are also popular because they’re more desirable and interesting than a ‘boring old’ bank account. Many customers of organisations like to hold shares in them, for sentimental reasons if not for pure investment purposes (just like football supporters held shares in Manchester United before it was taken private). It is exciting to think that by purchasing shares in Land Securities plc, you are purchasing a fraction of the famous Piccadilly Lights. [Photo below]

 

Simon OatesWhy Are Stocks & Shares a Good Investment?