Getting Started in Shares For Dummies Australia. Dunn James
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that income. When you buy a share, what you’re really buying is a share of a future flow of profits.
Now you know what you’re getting when you buy shares. You become a part-owner of the company. As a shareholder, you have the right to vote on the company’s major decisions. Saying ‘I’m a part-owner of Qantas’ sounds so much more impressive than ‘I’m a Qantas Frequent Flyer member’. Just remember not to insist on sitting in with the pilots; as a shareholder, your ownership of Qantas is a bit more arm’s-length than that. That’s what shares were invented to do: Separate the ownership of the company from those who manage and run it.
When you’re a shareholder in a company, you can sit back and watch as the company earns, hopefully, a profit on its activities. After paying the costs of doing business – raw materials, wages, interest on any loans and other items – the company distributes a portion of the profit to you and other shareholders; the rest is retained for reinvestment. This profit share is called a dividend, which is a specified amount paid every six months on each share issued by the company. Shareholders receive a dividend cheque for the total amount earned on their shareholding.
If the company makes a loss, shareholders are not required to make up the difference. All this means is they won’t receive a dividend cheque that year, unless the company dips into its reserves to pay (for more on dividends, see the section ‘Dividend income’ later in this chapter). However, if a company has too many non-profitable years it can go under, taking both its original investment and its chances of capital growth with it.
Companies that offer shares to the public are traded on the sharemarket as limited companies, which means the liability of the shareholders is limited to their original investment. This original investment is all they can lose. Suits for damages come out of shareholders’ equity, which may lower profits, but individual investors aren’t liable. Again, shareholders won’t be happy if the company continues to lose money this way.
Shares aren’t much good to you without a market in which to trade them. The sharemarket brings together everybody who owns shares – or would like to own shares – and lets them trade among themselves. At any time, anybody with money can buy some shares.
The sharemarket is a matchmaker for money and shares. If you want to buy some shares, you place a buying order on the market and wait for someone to sell you the amount you want. If you want to sell, you put your shares up for sale and wait for interested buyers to beat a path to your door.
The trouble with the matchmaker analogy is that some people really do fall in love with their shares. (I talk about this more in Chapter 7.) Just as in real love, their feelings can blind them to the imperfections of the loved one.
Because shares are revalued constantly, the total value of a portfolio of shares, which is a collection of shares in different companies, fluctuates from day to day. Some days the portfolio loses value. But over time, a good share portfolio shrugs off the volatility in prices and begins to create wealth for its owner. The more time you give the sharemarket to perform this task, the more wealth the sharemarket can create.
Buying Shares to Get a Return
Shares create wealth. As companies issue shares and prosper, their profits increase and so does the value of their shares. Because the price of a share is tied to a company’s profitability, the value of the share is expected to rise when the company is successful. In other words, higher quality shares usually cost more.
Successful companies have successful shares because investors want them. In the sharemarket, buyers of sought-after shares pay higher prices to tempt the people who own the shares to part with them. Increasing prices is the main way in which shares create wealth. The other way is by paying an income or dividend, although not all shares do this. A share can be a successful wealth creator without paying an income.
As a company earns a profit, some of the profit is paid to the company’s owners in the form of dividends. The company also retains some of the profit. Assuming that the company’s earnings grow, the principle of compound interest starts to apply (see Chapter 3 for more on how compound interest works). The retained earnings grow and the return on the invested capital grows as well. That’s how companies grow in value.
Ideally, you buy a share because you believe that share is going to rise in price. If the share does rise in price, and you sell the share for more than you paid, you have made a capital gain. Of course, the opposite situation, a capital loss, can and does occur – if you’ve chosen badly, or had bad luck. These bad-luck shares, in the technical jargon of the sharemarket, are known as dogs. The simple trick to succeeding on the sharemarket is to make sure that you have more of the former experience than the latter!
When creating wealth, shares consistently outperform many other investments. Occasionally you may see comparisons with esoteric assets, such as thoroughbreds, or art, or wine, which imply that these assets are better earners than shares. However, these are not mainstream assets, and the comparison is usually misleading. The original investment was probably extremely hard to secure and not as accessible, and not as liquid (easily bought and sold) as shares. Of the mainstream asset classes, in terms of creating wealth over the long term, shares usually outdo property and outperform bonds (loan investments bearing a fixed rate of interest); however, in more recent comparisons, shares have been weighed down by the GFC slump. The latest 20-year comparison – which incorporates this slump – is shown in Figure 1-2. Australian shares generated a gross return of 9.5 per cent a year over 20 years, which was beaten by residential property, which earned 9.8 per cent a year – but when tax was taken into account, the impact of franking credits helped push shares to best-performing status.
Shares offer a higher return compared to other investments, but they also have a correspondingly higher risk. Risk and return always go together – an inescapable fact of investment, as I discuss in Chapter 4. The prices of shares fluctuate much more than those of property, while bonds are relatively stable in price. The major risk with shares is that, if you have to sell your shares for whatever reason, they may, at that time, be selling for less than you bought them. Or they may be selling for a lot more. This is the gamble you take.
Everybody who has money faces the decision of what to do with it. The unavoidable fact is that anywhere you place money, you face a risk that all or part of that money may be lost, either physically or hypothetically, in terms of its value. The simplest strategy is to deposit your money in a bank and leave it there. However, when you take the money out in the future, inflation (the rate of change in prices of everyday items) may decrease its buying power.
Risk is merely the other side of performance. You can’t have high returns without running some risk. You can lower risk through the use of diversification – the spreading of your invested funds across a range of assets, as explained in Chapter 5.
Figure 1-2: A comparison of the growth of investment in different asset classes over the past 20 years.
Source: Australian Securities Exchange/Russell Investments