What to consider when investing in the stock market?

At first, the stock market can appear a daunting prospect. Hundreds if not thousands of companies to choose from, a range of different markets, a bewildering choice of brokers, investment strategies and trading methods, and a regulatory backdrop that speaks of precipitous decisions, misleading information, corporate finance deals creating unimaginable quantities of wealth, and plenty of evidence that, as responsible stockbrokers always caution, share market investment is not for everyone. How to make sense of the innumerable opportunities, risks and different approaches to the market?

The starting point for all investment is risk, and never less than in the stock market. Unlike a bank deposit where only credit risk need be entertained, share values can most certainly oscillate and even touch zero. Dividends likewise are never guaranteed, whilst the most profitable investments can frequently be those that for decades do not even pay dividends at all. Market risk is omnipresent; but so is liquidity risk, the danger that an investor may not be able to sell without a heavy loss, although stock markets by their very nature are aimed at alleviating this particular risk. Overall, any investor must develop a risk appetite: they must decide how they will measure risk – a frequently used measure is the relationship between overall return by comparison to the market as a whole and the range of stock prices over a given period, known as the Sharpe ratio, but this ignores the lack of correlation between corporate bankruptcy and volatility – no measure of risk is perfect.

Then they must decide how much risk is acceptable for the target return. That includes at least three issues. First, diversification requirements. A few companies may be identified as star performers, but most investors are rightly wary of too narrow a portfolio, whether by sector, by stage of development, by regional or national focus or by technology. Many individual investors choose collective investments such as Exchange Traded Funds (ETFs) for precisely this reason. Second, the need for either capital gains or regular dividends, and the duration of investment – whether to become a trader, or stick with passive or virtually passive investment – which is part of the suite of risk analysis, including how much time the investor plans to allocate to stock market trading or market watching. And finally, currency risk: stock markets in developing countries usually provide a better return in local currencies for good reason – there is a risk against the US$, sterling or whatever reporting currency the investor actually has and against which the portfolio will be measured in terms of performance. The stock market is only one potential destination for investment funds – another step in the process is to make a thorough comparison with alternatives – including, in current market conditions and at least for the bold, Initial Coin Offerings rather than the more conventional Initial Public Offerings. The outcome will depend on highly personal considerations – age, income, wealth, expenditure requirements, and planning – or their parallel in fund management, the stated objectives of the fund and the requirements of unit holders. It is, inevitably, a dynamic process that repays constant review.

After risk appetite is determined, the next quest for the investor is information. Recent share prices, historical dividends, market performance and the macro-economic background are key components in the vast panoply of data that investors will need to analyse. The type of data they will need will depend, however, on the investment approach taken. A fundamental investor seeks to predict stock market prices on the basis of real world economics and specific company events. By comparison, a technical stock market investor seeks to derive and extrapolate patterns from share prices. Either way, accurate information is crucial for the investment decision, and what is certain is that markets behave cyclically: timing is crucial for successful stock-market investment.

So too are good, reliable brokers and advisers who provide background information on companies and are regulated to provide investment advice. Smart investors also take careful note of how their advisers are compensated. Not all investment advice is as neutral as it should be: advisers themselves may have interests in the securities themselves, and may even have quite different private perspectives on the attractiveness or otherwise of particular investments than their public advice would suggest, an ethical and legal minefield for advisers and clients alike.

Beyond professional investment advice, getting ahead of the curve as a fund manager or professional investor requires greater understanding of the internal workings of corporates themselves. Part of the secret to the next stage therefore lies in corporate finance training. This provides expertise on issues such as share splits, rights issues, share buy-backs, alphabet stocks, spin-offs and split-offs, and all the other corporate finance techniques that play an enormous role in creating additional value for listed companies. Most investors hold miniscule percentages of corporate stock – the largest investors, fund managers, pension funds and others, do however have the capacity to intervene, through their voting rights, in corporate decision-making.

What is now striking is the globalisation of this entire approach. Studies from as far apart geographically as Bangladesh, Kenya and Papua New Guinea are now reiterating the approach pioneered in Western stock markets. Globalisation is making stock market investment a truly worldwide activity, with lessons learned now being universally applied.

Author Julian Roach of Redcliffe Training

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