Now that you understand what shares are, how the stock market works and where stock brokers fit in, you are ready to learn about selecting shares, different types of shares and the wonder of diversification.
Selecting your first share is quite terrifying. It becomes even more daunting when you tell people about it. Before acting on a hot tip from a family member, ask yourself why the person giving you advice hasn’t made a fortune buying that share themselves. Then ignore it.
Selecting a share is about educating yourself and trusting your own judgement. Start with these four steps:
- Buy companies you understand. Before you buy a share, ask yourself if you know how the company makes money.
- Buy companies that have been around for a long time. Can you remember if that company was around when you were a kid? Do a quick online search to find out about the history of a company. This rule of thumb doesn’t mean new companies are always bad investments, but it should help you think about whether a company has what it takes to be around for a lifetime.
- Don’t buy companies that all do the same thing. If some external event only affects a certain type of company, all of your shares could lose money at the same time.
- Don’t confuse your experience with a company with how the company is run. It is possible to have a bad experience with an employee of a great company. Instead, ask yourself if you understand how the company makes money.
You can also buy one share that gives you access to a lot of shares at the same time. Read about unit trusts and ETFs here.
You’ve probably been discouraged from putting all your eggs in one basket at some point in your life. While we abhor the cliché, we can’t argue with the logic. When it comes to your money, it’s a very good idea not to put everything in once place. On your investment journey, you will hear the word “diversification” regularly. In this article we will explain what diversification is and offer a few thoughts on how to achieve it.
When should I diversify?
Different types of savings and investments do different things. Having money in the bank protects your money against bad events that happen to shareholders. Buying shares helps you earn more money than if you left all your savings in the bank. Buying a second property or property shares helps your money grow even when external events affect the stock market.
When you plan your financial future, you should cover as many bases as possible. Some of your money should be in the bank in the form of an emergency fund. You should use some of your money to buy shares and some of your money to invest in property.
When you invest in shares, you can diversify even further by ensuring you don’t invest all your money in the same company.
Why can’t I put all my money in one place?
When you buy a share in a company, you assume that the company will continue to do good business for a long time. If the company does good business over time, your share price will go up and you will make money.
Unfortunately there aren’t any guarantees when it comes to investing. Things do go wrong with companies sometimes. The market might turn, companies can be mismanaged or customers might no longer want a company’s product. In any of these events, the company’s share price could go down to below what you paid for a share. If you sell your shares at a lower price, you will end up with less money than you had before you bought the share. Your investment would have lost money. This is what people mean when they talk about investment risk.
If you used all the money you had to buy shares in only one company and that company’s share price dropped dramatically, you would be in a worse financial position than you were before you bought the shares. In that case, you would have been better off just leaving your money in the bank.
How can I protect my money?
Fortunately, you can protect your money when buying shares by investing in different industries, companies and products.
Why do I need to invest in different industries?
Companies are affected by things that happen in the world. For example, if there are floods in an area of the world that produces rice, companies that make rice-based products will likely be affected by the event. An event like this can cause the company to earn less money in a year. When a company makes less money, many investors will want to sell their shares in that company, which will bring the share price down.
However, a company that produces spare parts for luxury cars will probably not be affected by the floods. Those companies will still earn money and won’t have to worry about the price of rice.
When we refer to industries, we mean businesses that all do the same type of work. For example, your favourite grocery store is in the fast moving consumer goods industry, while your bank belongs to the banking industry. A flood is more likely to affect your grocery store than your bank, while a global financial crisis will probably affect your bank.
When you start thinking about which shares to buy, choosing companies that do different things will protect your money against events beyond the control of those companies.
Why do I need to invest in different companies?
The first reason to buy different companies is to ensure that you are invested in different industries, as we’ve already discussed. However, you might want to own shares in two grocery store companies and two banks. This is a good idea to protect your money against things that can go wrong within a company.
Have you ever read a negative story about a company in the news? Perhaps something was wrong with the product the company produced or perhaps management were stealing money from the company. Events like these do occur from time to time. When a company is in the news for all the wrong reasons, shareholders want to get rid of their shares very quickly. Once again the share price of that company will drop, even though the news event doesn’t affect the whole industry.
If you bought shares in two grocery companies and one is in the news for all the wrong reasons, your shares in the other grocery company will continue to make money.
You already know what a share is. You also understand that you can invest in ordinary shares, in property and in bonds. You understand that investing your money in different companies and different types of shares will better protect your money.
TIP: Skipped a beat? Find out how investing works here.
If this all makes sense to you, take a moment to congratulate yourself. It’s a big deal! By now, you are probably wondering how on earth to select the right companies and bonds. There are so many options available. If you’re just starting out, it can be overwhelming.
Thankfully there are things called collective investment schemes (CIS) to help you.
What is a collective investment scheme?
Collective investment schemes are a lot like cakes. To bake a cake, you need a few ingredients – flour, sugar, eggs, milk and baking powder. When you add all of those ingredients together and bake them, only one delicious cake comes out of the oven. Most of us don’t eat a whole cake in one sitting, so we buy a slice (or two) of the cake to enjoy.
Collective investment schemes are also made up of ingredients – shares in different companies, property shares, bonds and cash. All of those ingredients are baked into a product. As an investor, you buy a slice of the product, which is called a unit or a share.
When you eat a slice of cake, you are actually eating five different ingredients. When you buy a unit or a share in a collective investment scheme, you are actually buying all the different ingredients that make up that product.
So what exactly can I buy?
There are different types of collective investment schemes, but our favourites are:
- Unit trusts; and
- Exchange traded funds (ETFs).
What are unit trusts?
Different types of assets can be put into a special kind of account, called a trust. Unlike normal bank accounts, trust accounts are managed by a designated person or company, called a trustee. A lot of the time, more than one person benefits from trust. A person benefiting from a trust is called a beneficiary.
A unit trust is a type of collective investment scheme. The account has the type of assets ordinary people would like to invest in. For example, a trust can be made up of shares in different companies, shares in property companies and some bonds. It can even have some cash in the bank. The trustee decides which companies to invest in and how much of each type of asset should be in the trust. The trust then buys all of those assets and stores them in the account.
You can become a beneficiary of the trust by buying one or more slices of the trust. In this case, the slices are called units. Just like buying a slice of cake actually gets you some egg, flour, milk and baking powder, buying a unit in a unit trust gets you some of all the shares, property, bonds and cash held by the trust.
Not everybody likes chocolate cake. Some people prefer carrot cake, and others like lemon meringue. Similarly, not everybody wants the same type of investment. Some people might prefer to own a lot of shares, but only a few bonds. Others might worry about having too many shares and would feel safer having some cash. You can choose a unit trust that holds the type of assets that you prefer.
What is an index?
An index is a way of tracking the performance of a group of companies on an exchange. It’s normally graph representing the share price of a particular group of companies. The graph goes up or down based on the average share price moves of these companies.
It’s so easy that you can even make your own index. Think of companies where you regularly shop that are listed on the exchange. At the end of every day, find the share price of all those companies on Google. Add all the prices together and place a dot on a graph that represents that amount. You’ll soon notice that some days the dot is higher than the previous day, and some days it’s lower, depending on the share prices of all those companies. Cool, eh?
In South Africa, the most popular index is the Top 40 index. This index tracks the 40 biggest companies on the JSE.
What does an index have to do with collective investment schemes?
Now that you know what an index is, we can look at another type of collective investment scheme called an exchange traded fund (ETF).
An exchange traded fund is a type of product that buys shares in all of the companies in an index. If an index tracks five car companies, a company can make a product by buying shares in each of those five companies and then selling slices of that product to the public.
When the five companies do well, the index goes up and the ETF does well. If the car industry struggles and the companies don’t make money, index goes down and so does the ETF.
Who makes ETFs?
Banks and other financial institutions make ETFs. The ETF products then lists on the exchange, just like a company. Investors like us can buy the ETF products through brokers.
You’ve already come a long way in understanding the world of investments. In case you missed it, we explain all the basics in our article on how investing works here.
There are different types of shares that do different things for investors. In addition to shares in public companies, you can also buy shares in property or property companies.
What is property?
Property can refer to an empty piece of land or to a building and the land on which it stands.
What does investing in property mean?
When people talk about investing in property, they mean they buy shares from a company that either:
- Owns buildings and rents it out to tenants; or
- Develops and sells property.
People like to invest in property companies that rent out property, because that rental income is shared among investors, just like dividends in a normal company. Think of it as owning a house and renting out the rooms. Property companies are alluring to people who need regular cash payments, for example retirees who no longer earn a salary.
Companies that buy empty plots of land in order to build new houses, apartments, offices or shopping centres are called development companies. Investors like these companies, because they often earn a lot of money in a short time by selling these properties once the buildings are complete.
Some property companies buy empty plots of land, build buildings on the empty land and then rent out the buildings.
How do I invest in property?
Just like any other type of company, larger property companies are public companies, which means they are listed on an exchange. In South Africa, we only have one exchange, called the JSE. Just like investing in any other public company, you can buy shares in property companies through a broker.
TIP: Still not sure what a broker does? Click here.
Isn’t it strange that debt can be an investment? Unfortunately we don’t mean the kind of debt that gets you the latest threads. It’s actually more accurate to say lending money to someone else can be an investment.
How can debt be an investment?
When you borrow money from the bank, you don’t only pay back the amount you borrowed. In exchange for giving you the money when you need it, the bank charges a fee and interest. That is how the bank makes money.
If you lend money to your friend, you can ask them to pay you a small fee for every month they don’t pay you back. When they do pay you back, you get the original amount they borrowed, as well as that fee. Your money earned more money, which makes it an investment!
What does this have to do with shares?
There is a special type of share that you can buy at the stock market. Companies or the government sell these certificates when they want to borrow money. They are called bonds.
How are bonds different from shares?
As we already discussed, the price of a share changes depending on how well the company is doing. If you bought a really good share, the price can go up over time and you can eventually sell it for more than you paid for it. You can also earn dividends on a share.
Bonds are more like lending money to a friend. The company or government that sells this certificate tells you when they will pay you back and what fee they are willing to pay to borrow money from you. The fees are usually paid out to you in intervals over the loan period, for example every three months until you get back the full amount they borrowed.
Why would I want to buy a bond?
Bonds are considered a safe investment, because you know that you are very likely to receive back your original loan, as well as the fee for lending the money. If something goes wrong with a company that borrowed money from you, the company is required by law to pay you back before worrying about shareholders who bought ordinary shares.
While you are protected if something goes wrong, you don’t benefit when things go well either. You will always only receive the amount you agreed to when you bought the bond, even if the company’s ordinary share price goes up.
Bonds are a good investment for people who want to take very little risk, but still want to earn some money.
What does the government have to do with it?
Just like people and companies, governments all around the world borrow money from their citizens. Unlike companies, governments are very unlikely to go out of business (and if they do, you have bigger problems than your investments). Governments can issue bonds through the exchange, just like companies, or they can issue bonds directly to the public. In South Africa, you can buy Retail Savings Bonds directly from the National Treasury, the South African Post Office, or Pick n Pay stores.