This is the second blog post in my three-part series on buying shares. Have you read part one of this series? If not, I suggest you head on over there now and get the lowdown. It outlines some things you need to consider before you get started.
Now that you’re up to speed and you’ve got all your financial foundations in place, let’s dive in.
Choose your approach
In part one of this series, I spoke about the importance of choosing an appropriate asset allocation. Whether you want to invest in domestic or international equities or require a wider mix of asset classes, most of the time you can implement that portfolio through the use of listed products. In this series, I will only be focusing on how you implement the Australian and International shares components.
When building your share portfolio there are a number of different approaches that you can take. This generally comes down to a few things. What level of control you want. How much time and energy you want to invest into research. And what your investment philosophy is.
Single Stock Portfolio
While this is the most labour intensive way to go about buying shares, some people love the thrill of building their own bespoke portfolio.
Creating your own portfolio allows you to have full control over what you are invested in. This can be really useful if you have a strong view of where the economy or a particular company is headed. It can also be useful to ensure that you are only invested in companies that operate within an industry or with a certain philosophy that you align with.
Top-Down vs Bottom-Up
In order to decide what shares you are going to buy you will first need to decide your investment approach. Are you interested in taking a top-down approach or a bottom-up approach? A top-down approach is one where you first take into account the macro factors in the economy (i.e. GDP and inflation). Then characteristics of the national economy (its government, its trade balance, etc). Finally, the things that could impact particular industries and then at the individual level.
Buying shares with a bottom-up approach focuses on an individual company and its management, challenges and other fundamentals first. This approach tends to be riskier as the focus is less on diversification and more on stock-specific opportunities (and risks).
Once you’ve decided on your approach it’s time to do your research. For top-down you need to work out your allocation to a market, an industry and then which companies within that industry. The next step (or first step for bottom-up) is to do your research at an individual company level.
It will be important to be able to read a company’s financial reports, as this will be where you can find inputs to calculate the P/E ratio, debt to equity ratio, profit margin, dividend payout rate and retained earnings, etc. There is no ideal result with respect to these ratios. It all needs to be considered in the context of the company’s goals, industry, and other economy-wide factors.
Keep in mind that while the fundamentals are important, stock-picking is as much an art as a science. The data has to be considered in light of the wider environment. This includes the opportunities or headwinds to its financial success. This includes in its actual profitability as well as the potential of its stock price. Remember that the trading price of a share isn’t necessarily representative only of the company’s fundamental value. It is also based on market sentiment (i.e. human emotion and expectation).
Also, remember that every company will be affected by a diverse range of factors, ranging from Economy-wide events (i.e. COVID-19) to company-specific factors (i.e. a new C.E.O.). That is why it’s not only important to keep yourself updated with what is happening in the economy, but also why it’s so important to diversify. You will never be able to predict everything that has a potential impact on a company’s share price or bottom line.
Finally, if you want to build a bespoke portfolio but don’t want to do individual research, you can source research reports from various brokers (sometimes free, sometimes at a cost). Their analysts will do the research and give a buy, sell or hold recommendation.
Exchange Traded Funds
If you just read the last section and thought “Agh, it all sounds too complicated”, don’t panic!
Not everyone is as excited about fundamental stock research and monitoring the leading indicators of the economy. Some people just want to invest in a diversified portfolio that represents the market, without having to pay someone to manage it. That is where ETF’s come in.
ETF stands for exchange-traded fund. An ETF is a single listed asset that holds a portfolio of shares in equal weighting to the market that they represent. While they are managed, they are not active, which means that they don’t adjust the portfolio weightings based on their view on where a particular company or the market in general is going. Because they are passive, they’re low cost compared to investments such as managed funds. They are also easy to buy and give you cheaper and easier access to diversification (i.e. less trading for more exposure).
Typically, ETFs track what’s known as an index – a list that measures the stock market, or a part of the stock market. There are lots of indexes including well-known ones like the ASX 200 (the top 200 companies on the ASX). If you buy an ETF that tracks the ASX 200 then you will own (a share of) a portfolio of all the top 200 companies on the Australian stock market.
When deciding what ETF’s to buy, look for ones with high volume (total number of trades) and liquidity (number of trades at any one price). Consider also the management costs, what index they represent and be sure that the unit price tracks closely to the NAV (net asset value) of the fund.
There are also specialised ETFs, such as ones that focus on high dividend stocks, sustainable companies or certain industries, for example, technology. Make your decisions about what to invest in based on the asset itself and the exposure you want.
As you can see, if you want to start buying shares ETFs are a great way to start.
Listed Investment Companies
If you’re interested in taking a more active approach, i.e. trying to outperform the market, then a LIC may be for you. A LIC is literally a Listed Investment Company. It operates like any other company listed on the stock exchange. Instead of making money by selling goods and services though, they invest and manage a portfolio of underlying assets. Many of those assets could be listed, but aren’t always.
The main difference between an ETF and LIC, other than the passive vs active approach, is the structure. A LIC has a closed structure (i.e. has limited shares that were decided upon at listing). Therefore the share price can differ significantly from the NAV (net asset value). This isn’t necessarily a good or bad thing, but does carry more risk. The price is based on other people’s perception of its value as well as its fundamental value. See above in the Single Stock Portfolio section.
If you’re comfortable with this risk and believe in the abilities of the investment experts and their methodologies, this may be the right option for you.
The downside of actively managed share portfolios (managed fund or LIC) is that most don’t outperform the market. On top of this, their fees are higher. So, before signing on the dotted line, make sure you’re clear on the fund’s past performance, what their specific strategy, the price vs NAV and how much they charge to manage the fund.
One final word on buying shares. While the most common way to get access to a share in a company is to buy on the stock market, it is not the only way. While reserved for the usually very wealthy, private access to equity in a company is possible too. And don’t forget, starting and building your own company is always an option too.
In the next and final instalment in this series, I will go into the how of buying shares. From choosing a trading broker to the terminology you need to know to place that very first trade! You can read that here.
If you have any questions or want more useful investing information, come and join the conversation over on Instagram.