Ever contemplated investing in shares but don’t know where to start?

Before you do, it’s important to understand what shares are, how they work and why the bulk of adult Australians who own shares – directly or through managed funds/super – see it as a primary strategy for generating long-term wealth.

Shares are units of ownership in any company that’s listed on the Australian Securities Exchange (ASX) or any other stock market globally that people can choose to buy or sell, also referred to as trading. When you buy even a small number of shares, you effectively own a small part of the company.

This means you are entitled to a share of their profits called dividends, and while many listed companies pay dividends twice annually, others may pay more or less frequently.

People typically aim to sell shares for a profit by buying them for a lower price, and selling them at a higher price, at some time into the future. This is based on the underlying expectation that good stocks will be more valuable into the future than they are today. 

How do shares work?

 For every prospective buyer of shares there must be a corresponding seller. A trade occurs when both buyer and seller reach a mutually agreeable price on which the transaction can be completed, and it’s the job of the share market to ensure that buyers and sellers find each other.

Shares in any stock can be traded continuously during the hours a share market is open.

How to trade shares?

Most shares are traded electronically on a share trading platform, with buy and sell orders being placed via computers, and matched online by exchange-operated software. While some people prefer to trade shares themselves (online) via a trading platform, others prefer to engage a full-service broker to handle it for them.

Why are shares a great wealth-generating strategy?

The price of shares can go up or down based on any number of factors that impact investor sentiment, including company announcements, interest rates, and the political or macro-economic climate.

Despite the degree to which the share price rises and falls over the short-term in response to investor sentiment (aka volatility), share markets have historically outperformed other asset classes (like property, cash and fixed income) over the medium to long-term.

This is why shares are generally regarded as good long-term investments.

What are the most common investment strategies? 

The three most common strategies for share market investing include:

1. High dividend

This is where people are attracted to stocks paying a sizable portion of profits as a dividend, and they’re usually referred to as income stocks.

2. High growth 

This strategy is ideal for those who are more interested in buying companies with high growth prospects in the expectation that this growth will eventually be reflected in a higher share price, which means they can sell their shares at a higher price than they bought them for.

3. Speculation 

This is where traders are less interested in investing in good quality business for the long-term – based on what are called fundamentals (like quality earnings, balance sheet, and future growth etc – and are more focused on speculating on share price momentum for short-term profit.

Ideally, the investment strategy you choose will depend on how much you have to invest, for how long and your investor risk profile, which can be measured by a risk profiling tool recommended by a financial planner.

Given the short-term volatility within share markets, the high risk ‘speculation’ strategy is more akin to gambling than investing, and as such is typically the domain of seasoned and wealthier share market traders, rather than inexperienced investors.

A safer approach

Whether you favour a high yield and/or a high growth strategy, the safest approach is to ensure you only buy quality companies that have good underlying businesses. That means looking for companies that have what are referred to as ‘sound fundamentals’, these include, a solid balance sheet, preferably with lower debt levels; sustainable core earnings; a highly regarded management team who have a track-record in delivering good year-on-year profits for shareholders.

However, buying companies with ‘sound fundamentals’ is only half the story when it comes to taking a safe approach to stock picking. It’s equally important to know how much the stock is worth paying for, relative to its future prospects. Just because a company has sound fundamentals doesn’t mean you should consider paying any price to own it.

Part of the ‘safe strategy’ approach is to buy these stocks when they’re trading at a discount to how much they’re really worth. This is typically referred to as a stock’s intrinsic value, which simply put – is the sum total of a company’s actual worth, based on its earnings, dividends, equity and debt.

Given that buying stocks when they’re over-priced, (relative to their intrinsic value) is one of the biggest mistakes share investors make, the strategy of buying good stocks at a price less than they’re worth, should return in spades. That’s because over the long-term, share prices typically reflect the actual value of the underlying business.

Money&Life, FPA