Investment choices - Shares
April 4, 2007There are tons of possibilities out there to invest and hopefully grow your money and the current obsession with derivatives certainly doesn’t limit that choice. Personally, I will stay away from derivatives until I can be sure that I understand what’s going on.
But let’s start with the basics and give you an overview of the most common investment choices. There’s on simple rule that applies to all of them: More risk, higher return. Whether you decide to keep your money under your mattress (and thus effectively lose money due to inflation) or invest it in a small start-up company depends entirely on you and your risk attitude.
A rule of thumb that is commonly used to determine the ratio of bonds and stocks in your portfolio is 120 - age. This is the proportion you should invest in equity (i.e. shares, equity-based funds, index funds etc.) and reflects the time you have left until you retire (if you are retiring in 5 years you will mind if your portfolio drops by 20% whereas if you have 40 years left you know you have plenty of time to make up for it). In my case this would be 120 - 20 = 100% in stocks, which is what I intend to do - after I’ve got some money sitting in a savings account with a sign round its neck saying “emergency fund”. At which point I can probably already invest 1% in debt-based securities (bonds…) 
I intend to break up this post into smaller chunks which should hopefully assure that (a) you don’t fall asleep, (b) you can look up the things you don’t know and (c) I don’t have too many good reasons to procrastinate from doing my revision.
So here we go with probably the most obvious choice: Shares.
Buying shares in a company effectively means you’re buying a tiny part of that company and thus have a right to have your share of their profits. Now with hundreds of thousands (or even millions, depending on the size of the company) of shares in issue this mostly boils down to a few pence per share. The profit is distributed to the shareholders (that is you) through dividend payments. Having said that, there are some companies who are not making any dividend payments but instead are using the profits to re-invest and grow the company. Depending on whether you want a solid income stream or growth from a share, you will have to make your choice.
The former group of shares is often classified as income shares, because they provide guaranteed income on a (semi-)annual basis. These companies are usually large firms whose demand doesn’t depend on economic conditions (utilities or pharmaceuticals come to mind) and you thus distribute their cash reserves to the shareholders. Likewise, these companies usually have a phenomenal market capitalisation (= share price x number of shares), which means that buy and sell transaction don’t affect the share price as much (Microsoft currently has a market cap of $280 billion). This however also implies that the share won’t grow as fast as a smaller share could. In short: the dividend payments are intended to make up for the lack of growth that can be expected.
Therefore, many of the companies classified as growth shares won’t belong to the category of dividend-paying companies (as with everything this is not a black-and-white decision - dividend policies can change and growth shares can also pay the odd dividend, but I’m talking stereotypes here…). These companies usually belong to more volatile market sectors (media, technology) and use all profits that are left over (after interest payments and tax) to fund further investments and thus grow the company. This will (hopefully) be reflected in future income statements (i.e. future profits) which in turn will help convince further investors to join the group of shareholders. Because these companies are usually smaller than income companies they are subject to greater share price movements - and as long as those are in the “right” direction, investors will make money through the increase in value of their shares.
Both income and growth shares belong to the category of common stock, which means that you invest in the ownership (equity) of a company and are allowed to vote for the board of directors every year - who are supposed to represent and act in the shareholders’ best interests. This, however, also means that in case of bankruptcy your claims towards the liquidated assets of the company are subordinated to preferred stockholders.
Owners of preferred stock are owning a part of the company in the same way that owners of common stock do, but with the major difference that dividends paid to preferred stockholders are usually fixed and paid out before the dividends to common stockholders whose dividends are variable (if paid at all). While this promises greater security, the old trade-off kicks in that determines “where there’s lower risk there must be lower return”: preferred stockholders don’t benefit from any growth in profits in much the same way as they don’t lose when profits plummet (as long as the company remains profitable - if it doesn’t, dividends are usually accumulated over time and paid as soon as profits allow).
This was surely a fairly lengthy introduction to the concepts, but I hope it was nevertheless helpful. If you want to read even more about shares and share categories now, I recommend you start here and here.
Read part 2 of “Investment Choices” on exchange traded funds >>
