Many people ask me ‘should I buy shares?’
My answer is always the same – “It depends what you are trying to achieve”.
They think about it for a second and say, “I want to make money”.
Well, there are many ways to make money. What you need to consider is, right now, what is the best way to maximise the money that you have available to invest and what level of risk are you willing to take.
You see, if you invested $10,000 into a bank account earning 3% p.a. and didn’t touch it, you would have around $20,000 in 24 years and essentially no risk of losing any of your initial investment. Whereas, if you invested $10,000 on a roulette table at the casino, you could have $20,000 in less than 24 seconds, but with a high chance of losing your initial investment.
Both of these ways can achieve your objective of making money, albeit with different levels of risk over different time frames.
Should I buy shares or are they risky?
If you were to buy shares in just one company listed on the stock exchange there is the possibility that you could lose all of your money if the company goes broke – even if it is one of the biggest companies. However, if you were to buy shares in 10 of the biggest companies on the stock exchange, the risk of you losing all of your money is very slim, because all 10 of those companies would need to go bust. What if you bought shares in 20 companies? Buying shares in a number of companies, which operate in different sectors (e.g. financial companies, health companies, mining, transport) is referred to as diversification.
The chart below is a basic representation of the risk of each investment class in any given year.
The table below shows the average, minimum and maximum returns of each asset class between January 1970 – December 2015 (courtesy Vanguard)
Asset Class,Avg p.a.,Min p.a.,Max p.a.
US Shares (S&P500),11.3%,-29.8%,62.7%
Australian Property (commercial listed),8.3%,-54%,50.3%
Australian Fixed Interest,8.4%,-10.1%,34.2%
This represents savings accounts and term deposits. As you can see, there is only an upside and generally no risk of losing any portion of your initial investment amount.
This generally refers to loans made to high-quality government and semi-government organisations. Interest rates received on such loans tend to be higher than standard bank or term deposit interest. Investment into fixed interest can easily be made via a managed fund. As you can see, the risk of a negative return in any given year is relatively small compared to the years that a positive return is expected.
Property carries greater risk than cash and fixed interest and therefore the possibility of property prices going downwards in any given year is higher, but so are the potential returns. This is where the term risk/return derives from: the higher the risk; the higher potential return.
And finally shares. the potential returns are greater again, but so too is the probability of having your investment reduce in value in any given year.
What this all means is that if you only have a short investment time frame (i.e. you will need access to your investment amount in 1-2 years) then you should probably limit your investment to saving accounts and term deposits. If you don’t need access to your investment amount for 3-4 years, then maybe you might consider fixed interest. But if you intend on investing for the long term and not touching this money for 7-10 years, then maybe shares and property would be suitable, provided that you understand your investment amount will fluctuate dramatically over the short-term, but should produce higher returns over the long-term (as long as suitable diversification is incorporated into your investment strategy).
The chart below illustrates the long term returns achieved in each ‘asset class’ from 1 July 1986-30 June 2016 (source Vanguard)
The long term trend has always been up.
Should I buy stocks now?
Trying to figure out the best time to buy shares is near impossible, no matter what any ‘expert’ tells you. Sure there are times when the probability of shares increasing in value is greater than the chance of them going down, but stock market returns are never guaranteed. The fact is, for all we know, tomorrow could be the beginning of the biggest ever market crash on record, or the start of the craziest boom we have ever come across. There are just way to many variables to know exactly.
So, how do you know if you should buy stocks now?
Something I like to use, as I’ve mentioned before in an earlier post titled ‘Is Now A Good Time To Buy Property‘, is the investment clock. You see, our economy is cyclical and has repeated on itself for decades. As shown in the investment clock below, beginning at 12 o’clock, real estate values rise, which is soon followed by rising interest rates, falling share prices and falling commodity prices. Lenders begin to tighten up and become conservative – making it more difficult to access borrowings – so property begins to fall too, because fewer people are able to get a loan and when they do it is less than when the economy is booming. However, at 7 o’clock interest rates begin to fall, as the government attempt to stimulate the economy by making it cheaper to borrow money, share prices begin to increase, banks begin to be less stringent on who they lend to and how much and, once again, real estate values begin to rise.
However, this is obviously a cycle that should be used as a very rough guide and the time it takes (months/years) between each hour on the clock varies between each cycle, so it is near impossible to figure out when the next ‘event’ or ‘o’clock’ will occur. But personally, I like to look at it now again, just to have a guess at where I think the economy is at and whether I should be buying shares now or not.
Should I buy shares or pay off my mortgage?
Okay, so purely from a financial sense, here’s how you should approach this. Firstly, figure out what your mortgage interest rate is. Let’s say it’s 5%. If your mortgage rate is 5% and it is not a tax-deductible expense, then you need to figure out the ‘effective’ rate of making a mortgage repayment, so that it can accurately compared to buying shares.
What on Earth does that mean? Effective rate?
Let me explain. Remember, we are trying to determine whether you should buy shares or pay off your mortgage.
Let’s assume you had $10,000 spare. What do you do with it? Well, if you bought some shares, those shares could increase in value over time and might pay you a dividend every six months. Let’s say, in the first year those shares paid you $500 in dividends. That would be a return of 5% ($500 divided by $10,000). But wait, you may have to pay tax on that dividend. If your tax rate is 30%, then you actually only receive a net dividend of $350, or 3.5%. Had you, instead, put that $10,000 on your home mortgage as an extra repayment, you would have saved interest of 5% on this amount, or $500.
See what we did there? So, assuming repayments on your home loan are not tax deductible, the interest rate is effectively an after-tax return of 5%. Meaning it is equivalent to a pre-tax return of 7.14%. Furthermore, it is guaranteed, because if you make an additional $10,000 repayment onto your mortgage, you are guaranteed to reduce your interest cost (in this case) by 5%. A dividend from a company can never be guaranteed.
So, unless you can find an investment that is going to provide you with a guaranteed, after-tax return of 5% p.a., then it will better to pay more off your mortgage.
However, this line of thinking does not take into account potential capital growth of your shares. Because, while we assumed a 5% pre-tax dividend amount, we didn’t take into account the share value increasing over that 12 months. What if, after 12 months your shares went up from $10,000 to $10,600 in value? Well, now you have a dividend of $500 (5% p.a.) and capital growth of $600 (6% p.a.) – a total return of 11% before tax. In Australia, tax on capital gains is not payable until you sell the shares, plus only 50% of the gain is taxable if you owned the shares for more than 12 months.
So now you need to figure out if this non-guaranteed, pre-tax return of 11% from the shares is better than the guaranteed after-tax return of 5% received by paying more off your home mortgage.
I’ll leave that one for you.
Buying shares in a company you work for
Many people like to buy shares in a company they work for. This is usually possible if your company is a large company listed on the stock exchange. Some companies will allow you to apply for shares directly with the company as part of an employee share scheme, or may even provide you with shares as part of your employment package.
Even though you work for the company, believe in the company and couldn’t ever conceive the thought of your company going broke; you should always consider the number one investment rule: don’t put all of your eggs in one basket. Remove any bias you might have in the company you work for and always manage risk by diversifying your money into several investments.
Don’t get me wrong, take any free shares they give you, but just be mindful that you don’t over-expose your hard-earned savings to the fate of one company.