Investing in Equities

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Investing in equities, stocks or shares all refer to the same thing – being a part owner of a company as a shareholder and participating in the profits and losses of the company, or companies, you invest in. There are two main ways of making money when investing in equities:
  1. Capital Gain
  2. Dividend Income

With respect to capital gain this can be done in more than one way. The simplest form is to buy an equity at a low price and then sell it at a higher price. However, one could also short an equity. The desired result is still to sell high and buy low, but instead of first buying the equity and then selling it the process is done in reverse. Thus, if one would expect an equity to fall in price one could sell the share (by essentially borrowing the shares from one’s broker) and then buy them back at a later stage. 

The risks associated with shorting are higher than the traditional way of buying and then selling later (known as “going long”). The reason is simple – if one buys €10,000 worth of shares the maximum one could lose is their €10,000 since a share cannot have a negative price and go down to €0 at most. In the case of shorting however the downside risk is much bigger. For example, if I sold €10,000 worth of a share at a price of €100 per share – so I would have sold 100 units (€10,000 divided by the price per share of €100) and the price subsequently skyrocketed to €250 per share and I was forced to close my position I would have to pay 100 multiplied by €250 = €25,000 to buy those shares. So deducting the €10,000 I would have gotten when I would have shorted the same shares, I would end up with a loss of €15,000, which is higher than the original amount I traded.

The above example is simple way to see the difference between the two methods of going long and of shorting. However, they are very extreme cases and are not as likely to happen. This is not to say that a company cannot go bankrupt (example after a major scandal) or cannot have its shares price skyrocket (example after the announcement of a takeover). However, through some simple risk management techniques such as sticking to the larger capitalised stocks and investing a portfolio of different shares, such extreme cases can be minimised and their impact on your overall wealth can be reduced significantly.  

Can equity investing be profitable?

The easiest way to answer this question is to look at a broad-based index such as the S&P 500 which is a US stock market index based on the market capitalisations of 500 large companies having equities listed on the NYSE or NASDAQ. 

The chart below shows the performance of the S&P 500 over the last 5 years from 5 April 2012 to 4th April 2017.


Investing in Equities

 

 

*Source: Google Finance

 

As can be clearly seen from the above chart the performance over 5 years of this equity index has been 67.57% equating to a 13.514% return per annum. Thus, it is true that double digit returns are still possible on equities and it has been the case for the last five years, based on real figures. What if we increase the time frame, perhaps the last 5 years were exceptional? The chart below shows the same S&P 500 index but over a 10-year-period from 5th April 2007 to 4th April 2017. Hence, it also includes the latest major financial crisis:

Investing in Equities
 
*Source: Google Finance

 

Some interesting points to note:

  • The 5-year and 10-year return on the same index are very similar which means that the annual equivalent of holding the same index for 10 years was 6.611% per annum (i.e. around half the last 5 year annual equivalent).
  • The price can go down and it can go down significantly. Anyone who bought at the highs of 2007 and was panicking in early 2009 and decided to sell could have lost around 50% of their investment. 
  • Investing in shares is a long-term game – the same person who invested in the highs of 2007 and decided to hold on to their investment would be gaining 66% currently. 

 

Does this mean that one should always invest in a broad range of equities such as buying an index fund that tracks the S&P 500 in a passive way? 

Not necessarily. Increasing the amount of equities within one’s portfolio is a good thing only until a certain point. Diversification (the lowering of risk by spreading the investment across different equities) will be a positive factor, however the amount of gain through diversification is reduced further and further the more equities one adds. One must consider that although increasing the amount of equities lowers the impact of the negative trades, it also reduces the impact of the positive trades. Furthermore, one also should consider other factors such as transaction costs and costs for maintain the portfolio. The smaller the amount that is invested per share the larger the cost since most brokerage firms will have a minimum cost per share and some also have safe-custody fees which is a fee for holding the equity on your behalf.  

Another factor to keep in mind when analysing the example above of investing into the S&P 500 is that we were just considering the more traditional method of investing buy buying and holding in a passive way. In the example, the investor would have bought at the begging of the period considered, left the investment running without any intervention, and then sold at the end of the period to make the capital gain. If we had to take a closer look at the ten year chart however it is clear to see that there were opportunities to make more than 66% by for example shorting the same S&P 500 between 2007 and the first quarter of 2009, by going long again from 2009 to the first quarter of 2010 and selling off again. 

This method of investing is called active management where an investor would try to anticipate market movements and earn returns above the market rate. Of course, we have the benefit of hindsight in our simple example so it would not be that easy to outperform the market. However, there are methods that exist that attempt to analyse the past patterns and directions of equities with the aim of anticipating future movements. Technical analysis is all about building models and trading rules based on observed price and volume changes. Back testing is regarded by many as highly relevant to creating models and algorithms that can trade equities in a long term profitable manner and in fact outperform the market. 

The Bottom Line

The aim of this post was to give a general introduction to equity investing. Locally, many investors tend to shy away from equities and they prefer fixed income investments such as bonds and bond fund since they pay more reliable regular income. However, given the interest rate scenario, which I have made reference to quite a lot in my previous posts, one has to be careful of the interest rate risk present in bonds and bond funds. Adding an element of equity investment to a portfolio could help mitigate the interest rate risk and diversify one’s portfolio to be positioned better for the months and years to come. There are different ways of investing into equities and I will be uploading more posts in the coming year which discuss such methods. One of the most advanced methods of investing into equities is through algorithmic trading. Anyone wishing to read more about this method should see my previous post here.  

Kyle Debono in the founder of FinancebyKD.com, a finance blog set up with the aim of providing financial education and investment ideas. Mr. Debono holds a Masters in Finance (University of London) and is the Managing Director, MLRO and Portfolio Manager at Novofina Ltd. He also offer his services as a Business Consultant to other investment services companies and is a visiting lecturer at the University of Malta, Banking and Finance Department.