Monday, July 26, 2010

The risks and benefits of investing in shares

The Risks of shares

Investors should be aware of risks with any type of investments. In order to receive a return for investing your money you need to accept a level of risk. Generally, the greater the risk the higher the return.

The following list is a summary of a few risks of investing in shares: 
  • Risk of capital loss - Investors are able to redeem the value of their share investment by trading them on the share market. When a company is not doing well, it may be difficult to find a buyer to purchase the shares at the price you are asking. As a result, the sale price may be lower than the original purchase price. You incur a capital loss when the value of you share has gone down when comparing to the value of the same shares at the time of purchase.
  •  Volatility risk - Share prices can rise and fall rapidly and investors must accept the fact that the value of their shares may fluctuate by as much as 50 per cent or more in a year. General market risk can relate to a particular sector, e.g. mining shares are usually more volatile than industrial shares such as bank shares. Specific risk can relate to the performance of an individual share.
  • Timing risk - Because of market cycles, some shares have a higher degree of risk when the overall share market has risen sharply and is set for a reaction. The opposite may apply when the market has gone into a strong decline and then starts to recover after showing some signs of stabilising. Not all sectors of the market follow the same price cycles. Understanding business cycles and how different companies perform during the different phases of the business cycle can help to manage the effects of timing risk.
  • The risk of poor quality advice - Are the investment recommendations made to you supported by a thoroughly argued case, or are they merely hearsay? The more reliable information you have, the better your decisions will be. Adopting a disciplined decision-making process will help you to minimise losses while you patiently build a portfolio.
The benefits of shares
  • Shares for capital growth - Capital growth occurs when the value of your investment increases. Many people invest for capital growth to build their wealth and protect themselves against inflation.

    People invest in shares because they offer the possibility that their price will rise. Owning shares in a company with a rising share price is one way to achieve capital growth.

    Capital growth is essential to investors as long as there is inflation. Inflation is a measure of the rise in the price of goods. The Reserve Bank of Australia (RBA) aims to keep inflation within a range of 2-3%. With no capital growth, your money will buy less in the future than it does now.
  • Shares for dividend income - A dividend is the distribution of a company's net profit to shareholders. Dividend yields vary greatly from company to company. It is not compulsory for a company to pay a dividend.

    For Australian investors, dividends are often worth more than the cash payment they receive. This is because a company can also distribute franking credits for any company tax it has paid.

    Franked dividends carry imputation credits, which entitle shareholders to a tax offset or a reduction in the amount of tax to be paid. If your marginal rate of tax is lower than the company tax rate, the excess franking rebate can be used to reduce the tax payable on other sources of income.

    In addition to rising share prices, dividend re-investment plans (DRP) can multiply the capital growth effect of a share investment. DRP is an alternative to cash dividends, allowing shareholders to purchase new shares instead of receiving a cash dividend. These shares are often issued at a discount to the current market price and no brokerage is paid.
  • Capital gains tax (CGT) - Shares enjoy good taxation benefits in comparison to most other investments. You realise a capital gain whenever you sell shares and the consideration received (sale price less related costs such as brokerage) is more than the cost base (purchase price plus related costs).

    If the shares were acquired on or after 20 September 1985, the capital gain must be included as assessable income in your tax return and is subject to CGT. CGT is payable at your marginal tax rate in the year in which you sell the shares.

    For shares acquired on or after 21 September 1999 and sold 12 months or more after the date of acquisition, capital gains may be discounted by 50%; meaning only half of the capital gains must be included in your assessable income.
  • Financial control - Shares' flexibility and liquidity are key advantages. In particular, the ease and low cost involved in buying and selling relatively small amounts and the control that gives you; whether to free up some cash, re balance your portfolio or simply realise a profit.

    Many people appreciate how easy it is to invest in shares. There is no conveyancing cost, stamp duty or ongoing expenses. You can do everything over the internet if you wish, and brokerage fees are much lower than typical real estate agent fees. So you can start small, buying companies you know, and take the time to learn as you go.
Please note that this is an Australian website. Laws and regulations will differ in different countries. It is of vital importance that you check your tax laws before investing in shares.

This article is based on the ASX share course, version 3 2008, course 3. (