Richard ReedWith interest rates set to remain low, investing in the stock market can be an attractive option – but it’s vital to plan ahead and draw up an investment thesis.
Your investment thesis should reflect both what you are hoping to achieve, and your appetite for risk. From there you can go on to define the type of stocks or funds you want to buy, and how you manage them once they are in your portfolio.
Remember, stock prices go down as well as up, and in extreme cases you could lose everything – those disclaimers on financial advertising are there for a reason.
However, one of the aims of drawing up a thesis is to minimise those risks and have a clear action plan as to how you will react if your new ‘buy’ starts heading south.
Risk appetite
Risk appetite is fundamental to investing in the stock market. Are you risk averse, just seeking to make a modest but steady return on a ‘safe’ stock or fund, in the absence of good savings rates at banks and building societies?
Or are you perhaps more of an adventurer, prepared to risk a loss in pursuit of double-digit returns?
Or you might prefer a middle course, putting a small amount of your investment pot into higher risk investments, but hedging that risk by putting your remaining cash in those steady earners.
Stocks or funds?
Once you’ve established your risk appetite, the next decision is whether you want to invest in stocks or funds.
Buying an individual stock – perhaps a glamorous high-flying tech company – can seem an attractive idea, particularly if it’s already on the rise. But it goes without saying that putting all your eggs into one basket is a highly dangerous proposition, even for someone who is not risk averse.
To reduce the risk and achieve a balanced portfolio you should be looking to hold at least 10-15 stocks, and you should aim to carry out some in-depth research into the underlying strengths and weaknesses of those companies. You also need to make time to review your holdings on a regular basis.
On the plus side, thanks to the internet it’s much easier to invest in stocks yourself. Gone are the days of paying expensive stockbroking fees – now all you have to do is log on to your online account and choose the stocks you want to buy.
There will be a small transaction charge, but it’s tiny compared with the fees of yesteryear – just make sure you shop around for the best deal.
Active funds
Investing in a fund that holds a basket of stocks on behalf of a big pool of investors is a much safer proposition. The fund manager and his or her team will have carried out in-depth research on the fundamentals of the companies they are buying and the markets in which they operate.
They will examine the companies’ financial health, the strength of the management team, their product pipeline, their dependence on certain customers or suppliers and other criteria.
If the fund holds the stock for any time, they will almost certainly visit the company to see first-hand how it is run, talk to senior management and assess the business for strengths and weaknesses.
Here, rather than buying a stock based on your own limited knowledge, you are buying into the manager’s much deeper knowledge, and also spreading any potential downside risk across the fund’s entire portfolio of holdings.
Funds can buy shares based on any number of criteria, such as consumer, manufacturing, tech and life-sciences, or by geographic region (eg Europe, North America, Pacific) or type of market (eg Emerging Markets).
Of course, you don’t get access to this knowledge for nothing – the typical annual fee is 0.85% to 1%. Furthermore, only roughly a quarter of these ‘active’ funds, as they are known, outperform the benchmark, or average, for the sector.
Passive funds
Rather than seeking to outperform the market, passive funds are designed to simply track the benchmark for the market – hence why they are sometimes known as ‘trackers’.
The strategy here is that by buying a whole raft of stocks in a particular market – a process that is largely computerised – the fund can emulate the overall performance of that market without incurring all the research costs of an active fund. The most competitive trackers charge less than 2%, although some do charge considerably more.
The performance of a passive fund is judged by its tracking error – in other words, how much under or over the benchmark it is performing.
Reviewing performance
Whether you are buying individual stocks or funds, you need to regularly review performance, selling those that are consistently underperforming and looking for new ‘buys’ that meet your criteria. That doesn’t mean you should be looking to sell the moment your holding hits a downward spike – it only takes a brief look at a graph of share price movements to see how volatile they can be on a daily or weekly basis.
Depending on whether you are looking for short-term rewards or long-term gains, you should be reviewing your holdings on a monthly, quarterly or annual basis. If you’re investing for the long term, then fund holdings are usually the best way to go, but you should still be keeping an eye on performance.
If you want strong, short-term returns and you’ve invested in individual stocks, then you need to keep your finger on the pulse and keep abreast of any news that might adversely impact your selection in anything other than the very short term.
However, beware of overreacting. It’s worth bearing in mind that although shares in most companies tanked after the UK’s Brexit referendum, they had mostly recovered within two or three months.
There’s many an investor who has sold a falling stock following a dose of bad news, taking a hit in the process, only to see the stock recover a few weeks later.
If, conversely, your stock is rising rapidly, you also need to consider the best time to sell. It’s safer to sell on the way up than on the way down – falls can be much larger and more dramatic than rises.