Why invest in shares? The advantages and risks of stock investing

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What’s on this page?

1. Is investing in stocks worthwhile?
2. Potential advantages to buying stock
3. Risk vs reward
4. Risks when buying stocks
5. Common vs preferred stock
6. ETFs and stocks
7. Managed portfolios

Is investing in stocks worthwhile?

Whether or not investing in stocks is worthwhile depends on your aim and alternatives that are available to you. If you are willing to take on risk, then investing in shares is a way to profit from stock prices going up and dividend payments.

However, remember that you could lose money and that past performance doesn't guarantee future returns.
There are two ways to earn a return on investment from the company shares you own:

1. Share price appreciation
2. Income from dividends

1. Share price appreciation

Share price appreciation occurs when you buy stocks and sell them at a higher price. The greater the difference between the buy and sell price of your stock, the higher your return on investment.

For example, investing in an index like the S&P 500, which contains 500 large US companies and aggregates their individual performances into a single index. Historical financial market data shows that the S&P 500 appreciated over a 25-year period and peaked at 370% return.

Note that buying shares in an index like the S&P 500 often yields better returns over time compared to individual company stocks since each carries its own risk.

2. Income from dividends

Dividends are periodic payments a company makes to shareholders from its revenue. Not all companies make dividend payments, meaning you’ll only earn these if the company you’ve invested in pays them.

Stocks that are known to pay regular and stable dividends are known as ‘dividend stocks’ or ‘income stocks’. Dividends can be paid into your account for withdrawal or used to buy more shares. Note that dividends from common stock and preferred stock are treated differently.

Earning a dividend income can make a huge difference to your returns over time. You can build long term wealth by reinvesting your cash divided using the compounding effect, yielding more returns from that lump sum. Compounding is exponential, meaning even though the initial amount might be small in the short term, the value of your investment portfolio will grow significantly in the long term.

For instance, if you’d invested £10,000 invested in the FTSE 100 at the beginning of 1986 and automatically reinvested any dividends you received, your investment would have grown to £195,852 due to compounding.

Potential advantages to buying stock

The potential advantages of buying stock is earning an income, mostly through passive investing. The returns form the stock market also tend to occur at a faster pace than the inflation rate.

The large number of buyers and sellers available on the stock exchange make stocks more liquid, making them faster to sell compared to real estate which are non-liquid assets that take longer to convert into cash. That being said, buying stock does carry risk too, which we explore later.

Here are some advantages that come with buying shares:

• Higher returns than cash investment. Cash investments are low risk, but returns are low, too. Shares are riskier, but the potential rewards can far exceed interest earned on savings
• Share price appreciation. Companies are productive assets in the business of earning revenue. If revenue (current or projected future earnings) increases, a share of ownership in the company becomes more valuable, too
• Dividends. You’ll be eligible to receive dividend payout on your investment earnings, provided the stock you’ve invested in pays these
• Protection against inflation. Although share prices often drop when inflation first hits, they adjust their value after a while, thereby protecting wealth against the corrosive effects of a rise in prices
• Diversification. This mitigates risk, as you can get exposure to many different markets. Especially through an ETF
• Liquidity. Stocks, unlike property or physical assets, can generally be sold quickly at the going market price. Property is often used as investment since they appreciate in value over time
• Small and discretionary outlays. Unlike property, you’re not required to pay a large outlay all at once, meaning you can invest small amounts at your discretion. With property and mortgages, you’re expected to pay the full value of the investment upfront
• Tax benefits. You’ll get tax benefits when investing in individual savings accounts (ISAs) and self-invested personal pensions (SIPPs)

Risk vs reward

The reason the above advantages are possible is because you assume risk when investing. Risk is the chance that you may lose some or all of your investment amount, which is a factor of uncertainty.

The more uncertain the outcome of an investment, the greater the potential reward you should be offered. How you decide to navigate risk depends on your individual preferences, or ‘risk appetite’.

Evaluating your appetite for risk

There are several things to consider when analysing your risk appetite. The top three are your investment aims and horizon as well as risk profile.

Risks when buying stocks

There are risks involved when buying stocks. That’s because all investment activities carry a certain level of uncertainty, and this is something you must give careful consideration prior to committing capital. Ensure that you make use of our risk management tools. These are some of the risks you’d need to consider:

• Investment risk is the level of uncertainty inherent in all types of investing. Often, the higher the return, the higher that risk. The type of investment risk you take depends on your risk profile
• Company risk is the level of exposure the stock you’ve invested in has due to circumstances that negatively impact profits, potentially leading to its failure
• Market risk is related to losses you might incur due to the entire market being affected by unfavourable price movements
• Share price volatility provides a measure of the overall value at which the stock market fluctuates up and down. These are at times unpredictable sharp price movements
• Exchange rate risk is when the change in currency exchange rates impacts the operations and profits of the company you’ve invested in
• Liquidity risk is when a company doesn’t have sufficient assets to be converted into cash so as to meet its financial obligations and timeously settling debts without impacting its share price
  

Common vs preferred stock

Common and preferred stock have different features. Which stock you buy depends on your aims.

• Common stocks enable shareholders to have voting rights at stockholder meetings and to receive dividend payments, provided the company pays them
• Preferred stocks are issued to shareholders as priority recipients of dividends. They usually don’t come with voting rights, but stockholders are likely to be able to claim earnings than common shareholders

If you’re investing in stocks seeking to earn an income or dividends, then you could consider preferred stocks. Here’s why:

As a preferred stockholder, your expected revenue stream tends to be more dependable since your dividend payout is a fixed amount and it’s prioritised above that of common shareholders. The income you earn from your shares is likely to be relatively higher compared to common stockholders.

Being a preferred shareholder, you’re privy to a variety of this type of shares such as cumulative and participatory preferred shares, to name a few.

• Cumulative preferred shares have a clause that protects you when company profits take a hit. These enable unpaid dividends to first be paid out to you as a preferred shareholder before common stockholders
• Participatory preferred shares refer to when you’re guaranteed additional dividend payouts above the normal fixed dividend rate, provided the company you’ve invested in meets specific financial objectives

Investing in ETFs vs stocks

Exchange traded funds (ETFs) are instruments that track the performance of a group of underlying assets. These can range from stock index ETFs, which track indices like the FTSE 100, to currency or sector ETFs that trail multiple currencies and companies in the same industry, respectively.

ETF shares offer a single-entry point for increased access to a wide variety of markets and assets, which helps to diversify your risk. With us, you can access over 5400 global ETF markets using the UK’s best platform.²

Managed portfolios

Managed portfolios are handled on your behalf. With our Smart Portfolios you’d get a diversified basket of assets – from low to high risk – depending on your risk profile, that would be managed by experts, increasing your exposure to the global markets. These would include fixed income and equity as well as alternative investments like commodities and real estate.

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