Understanding Stock Market Basics

When it comes to purchasing a house – the greatest financial investment most people make – we like to inform ourselves of everything we need to know. Area performance, interest rates, rental yield, area coding etc. Yet when it comes to the stock market, so many of us shy away from understanding even the most basic principles there is to know.

Whether you are actively involved in the stock market or devolve that responsibility to a financial planner, fund manager or superannuation fund, it is important to educate yourself on these basic principles of investing in the stock market so you can make informed decisions yourself, or provide appropriate direction to those managing your investment.

Here are some very basic things you should understand before investing in shares:

1. Understand your risk appetite

Any investment has an element of risk to it. Generally speaking, there is a relationship between how risky an investment is and how large (or small) the expected returns can be for that particular investment. For example, investing our money in a term deposit is a relatively safe investment to the extent that banks can even guarantee us a particular fixed percentage return per annum over the life of the investment. However, as the stock market has a far greater degree of unpredictability, positive returns can be far greater, as can losses.

It is therefore essential that you recognise what your risk appetite is and more importantly invest accordingly. Are you at the beginning of your career with a small valued investment portfolio that you are willing to risk? Or are you nearing retirement with a large valued investment portfolio and would prefer steady returns?

2. Create an investment strategy

Once you figure out your risk appetite, it is absolutely vital to have an investment strategy. Do you want to actively manage your portfolio, selling and buying shares every day? Or do you wish to leave your portfolio for 15 years untouched and benefit from capital gains? Perhaps you want a portfolio that has a strong dividend yield? Are you investing in smaller companies that have a strong growth potential? Or do you want to invest in ASX100 stocks?

As you can probably see from here, at all stages of creating an investment strategy your risk appetite will play an integral part in your decisions regarding how and where you invest your money.
What’s really important is that you stay true to your strategy. For example, if your strategy is long-term – say 3-5 years – it might be unwise to sell a stock if it drops 5% in value in the first 3 months. Stocks are volatile in nature and if you truly believe in the long-term viability of an investment, knee-jerk reactions to short-term volatility may only damage your investment strategy.

3. Understand the importance of diversification

A Forbes article published in 2012 recited a study which showed “100 monkeys throwing darts at the stock pages in a newspaper” could on average outperform the index by a margin of 1.7% per year since 1964. What this highlights is that diversification, no matter how random or thoughtless, is probably one of the safest and most effective ways to eliminate negative returns when investing in the stock market. Think of this very simple example: If you invested $5,000 in AMP shares before the recent Haynes Royal Commission there is a good chance you would have lost a substantial amount of your investment due to the market’s reaction to the Commission recommendations.

Isolating your investment in a single company or even a single share industry (for example, Banking) is a sure-fire way to make volatile returns. By diversifying your portfolio by investing in different sized companies in different industries with different targets and at different prices, the correlation between the different shares and their price behaviour is lowered. This means that in most cases, losses in certain shares are compensated by profits in others. While it’s true there are more transaction fees in diversifying your investment across different shares, it is always something you should always consider.

Even if the basics of share market investing is a little too difficult to grasp, the most important thing is for you to understand your investment ambition and risk appetite.

We provide investment management services and can help you create a portfolio appropriate to you.