This week we are going to talk about shares, probably the most well known kind of investment.
Shares are also known as equity, or stocks. We will use all three terms interchangeably.
What are Shares?
When you buy shares in a company, you are buying part of the company, meaning that you become a part owner of the company. As a part owner you have the right to:
Share in the profits of the company: Any profits that are distributed to shareholders will be paid to you as a dividend. Dividends are usually paid semi-annually.
Vote: When key decisions are made in the company, as a shareholder, you will have the right to vote. For example, you may get to vote at the Annual General Meeting (AGM) about which directors to elect, or how much company executives should be paid.
Shares are very different from bonds. When you invest in bonds, you are lending money to a company. When you purchase shares, you are becoming a part owner of a company.
Why Invest in Shares?
Shares are a key part of any investment portfolio. The top reasons why you would invest in shares are:
Capital Growth: Australian shares generated a higher investment return than either cash or bonds, with an average per annum return over the last 20 years of 8.70%. Investing in shares helps grow your investment (also known as capital) over time and achieve a portfolio growth rate that is ahead of inflation.
Dividends and Franking Credits: Some people invest in shares for the income provided by dividends. A further benefit, when you invest in Australian shares, is the franking credits that some shares provide.
A Franking Credit is a credit you receive for the tax that a company has already paid. A company will usually pay tax on its profits at a rate of 30%, if the dividend you receive is franked, you will receive a tax credit for the amount of tax that the company has already paid on that dividend. This will be particularly beneficial if your marginal tax rate is below 30%. For example, if you hold the shares in your superannuation account:
Prior to retirement (i.e. during the accumulation phase of your super): Any income you receive is taxed at 15%. This means that if you invest in shares that pay a fully-franked dividend, you’ll receive a tax credit of 30% and only pay tax of 15%, leaving you 15% better off.
In Retirement (during the pension phase): You don’t pay any tax on the income generated from your superannuation account. If you invest in shares that pay a fully-franked dividend, you’ll get the full benefit of the 30% tax credit.
How to Invest in Shares
When investing in shares you have a number of options:
Invest Directly: You could pick a portfolio of stocks to invest in. If you go down this route you’ll need to pick at least 20 stocks to ensure that you have some diversification in your portfolio, with the stocks spread between different industries and geographies. You’ll also need to keep on top of the performance of these stocks to make sure that their returns are in line with your expectations.
Invest via a Passive Fund: There are a number of exchange-traded funds (ETFs) available which give you access to different segments of the market. For example, you could purchase an ETF that gives you access to the ASX200, which is the largest 200 companies on the Australian Stock Exchange. There are also ETFs available by sector (e.g. healthcare) or by size of company (e.g. small cap stocks), or by geography (e.g. international ETFs). To invest via an ETF you are likely to pay a fee of between 0.10 – 0.50%p.a.
Invest via a Managed Fund: Alternatively, you could pay a fund manager 1 – 2% with the belief that they will pick well-performing stocks and outperform the passive funds or index. According to the SPIVA scorecard, only 26% of fund managers outperformed the ASX 200 over the last 5 years.
Interestingly, the majority (52%) of managers that focused on small and mid-cap stocks (which we’ll cover in more detail next week) outperformed the market over a 5 year period.This suggests that it may be worthwhile using a passive fund to invest in the ASX200, and a fund manager to access small and mid-cap stocks.
Too many shares?
Over the last 20 years, shares have generated an average return of 8.70% per year, so why not invest 100% in shares? The reason is risk. A higher return is always accompanied by higher risk.
The chart below shows the performance of the stock market over the last 10 years, as you can see the market still hasn’t returned to the highs of 2008.
In the period from November 2007 to end of February 2009, the market dropped by over 50%. That means that if you invested $10,000 in the whole of the market on 31 October 2007, by 1 March 2009 you would be left with $4,951 left. As at 31 December 2016 your initial $10,000 investment would be worth $8,387. Keep this in mind each time you are considering investing in shares. They are an important part of an investment portfolio, but shouldn’t form 100% of it.
The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs and before acting on the advice.