Dr Tony Stewart is a scientist and analyst by training. He has run a strategic market research business and has an extensive background in statistical analysis. At the beginning of his investment career, he read widely and undertook courses on investing run by the Securities Institute of Australia. He has invested in the Australian stock market for thirty years.
Breadtag Sagas ©: Author Tony, 1 September 2021
Investing in Shares 101: 1 Basic Concepts & Pitfalls
There are so many complex and simplistic guides to investing that confuse rather than inform. Shares 101 Basics addresses the problem. Shares 101 Basics is biased slightly towards Australia and the ASX (Australian stock exchange), but it applies generally to the USA and UK as well, which are usually in step.
The book I used in the 1990s to help me understand the basics of investing said:
These days, people who either own shares, get appointed as trustees, attend seminars or otherwise advertise their interest in investment matters, will soon find themselves receiving unsolicited material containing offers of assistance, ‘research opinions’ and newsletters. (Fitzherbert)
In today’s Internet era, this is magnified. Perhaps I am too suspicious when it comes to finances, but even an organisation that I support wholeheartedly, The Australian Shareholders Association, seems a little suspect in recent years in its educational activities.
A tour of my experiences in the share market might help those starting out. First, I am going to cover the basics. The second article 2 Value Investing will look at the best approaches to investing in shares. The third article will detail my personal experiences warts and all.
In Q Research, I often used the David O’Gilvie 1963 quote based on an earlier one: where he bemoaned the reluctance of marketing executives to use their own judgement; instead they use research as a drunkard uses a lamp post for support, rather than for illumination.
In this overview of best practice and my experiences of thirty years investing in shares, I want to offer illumination in Shares 101 Basics rather than support for your prejudices.
The target audience I have in mind in Shares 101 Basics are those wanting to begin investing in shares and looking for help. Although more experienced investors may benefit from a refresher or different perspective.
I call these target investors retail investors, like myself. In Australia, they were until recently pejoratively labelled mums and dads. Mum and dad investors are small-scale risk-averse shareholders, typically an ordinary person with a mortgage and family. (OED)
Before the Internet era retail investors were at a huge disadvantage to professional investors and organisations. Insider trading and sweetheart deals were rife then; and not much has changed. But, the advantage to the large and corporate investor has been greatly diminished by online trading and instant information. Nevertheless, the Gordon Gekko era whilst not as blatant still exists. And, corporations still have major advantages, such as, share placements, the ability to manipulate markets and the like.
Nevertheless, many mum and dad investors frequently perform better than professionals.
SMSFs in Australia
Self-managed superannuation funds are important in Australia for long term, retail investors, but irrelevant for those overseas. I’ll talk about them in the Further Information section.
Asset Classes the Basics
In simple terms for Shares 101 Basics there are three major asset classes:
- Property, and
Australians love the first two and often neglect or fail to understand the third.
Cash is liquid (capable of being withdrawn immediately to pay debt), not risky and not volatile (unless you are dealing in different currencies).
Shares are quite liquid these days (CHESS, online trading in Australia, has a three-day turnaround), potentially risky and volatile (especially in recent years).
Property is illiquid (not easily converted to cash), less risky and not volatile.
However, property does have boom and bust cycles (as do shares). But, you frequently don’t have much choice in what part of the cycle you have to buy and sell property in, whereas with shares you can buy and sell readily, at any stage of the cycle.
3 Shares, Property and Cash in More Detail
- Cash interest is usually not considered a good long-term investment.
- On a long-term basis, the share market gives annual returns of around 10% on capital, sometimes more (around 10% in the US also) and around 4-5% on dividends. Transaction costs have declined massively with Internet trading. (The service I use is not nearly the cheapest. It charges $19.95 for Buy/Sells of between $1000 and $10,000.) Transactions in the USA are even cheaper.
- Property returns around 6-8% on capital in Australia, but this depends on CGT (capital gains tax) and is quite variable. One expects roughly 4% return on net rentals. Transaction costs in buying or selling a property vary considerably, but are expensive compared with shares.
One usually expects slightly better capital gains on shares than property. Risk is perhaps higher in the share market. However, the figures above are indicative only, take them with a grain-of-salt. Actually calculating the average returns is incredibly complex and extremely variable.
I’ve enjoyed my career on the share market and tend to dislike property.
Although, I bought two small investment apartments in Sydney around the same time that I became engaged in the share market. I’ve done well on both, but better in shares and liked doing it much more. Horses for courses! Other people I know love dealing in the property market.
Enjoyment is important. If you don’t enjoy playing around with shares, if you break out in a cold sweat every time the share market falls: Don’t do it!
I’ll talk about franking credits for shares and negative gearing for property (both mainly Australian issues) in the Further Information section.
Cash must always be a component of a portfolio. Cash is usually not kept under the mattress, but hopefully in a bank in a high interest savings account or on term deposit.
Cash is usually not considered as an investment in its own right. Certainly at the moment, when cash rates are approaching zero, people are concerned about having cash in large amounts. I’m not!
But, I’ve stopped worrying about term deposits, even though it’s costing me a little money. Because it just isn’t worth the effort!
The idea that your money must be working for you is one of those pernicious ideas that is not only not true, it frequently leads to fear, confusion and asset destruction.
Patience is a virtue! If you lose money in the short term to gain it in the long term that is a good thing. If someone offers you a deal that offers a much higher rate than you can find elsewhere, be suspicious, the chances are you are going to lose your money.
An example occurred when we were in Brisbane in 2000. Jack Herbert at 74, Terry Lewis’s bagman, was retired. He said his money was only earning a lazy 5% so he was attracted to a scheme that offered to make him 14%. The real estate scheme was fraudulent. He lost every penny. If it looks too good to be true, it is!
Interest Rates and Inflation
Interest rates in Australia were over 10% for most of the period from 1985 to 1991. Term deposit rates were around 15-16% during some of this time. When the cash rate is this high, why be in a hurry to invest in shares or property?
There is a downside to high interest rates (it should be obvious, but may not be). Interest rates and inflation go together. When inflation is high, the value of your capital is being eroded. You may be earning great income, but your money isn’t worth as much.
Conversely, when interest rates are very low you may not be earning any income from your cash, but your capital value is preserved because inflation is low too.
The primary purpose of a stock market, in case you didn’t know, is to provide a vehicle for publicly listed corporations to raise capital. The secondary purpose is for investors to acquire part-ownership in publicly listed entities, and to be able to trade those shares of ownership readily.
It is very important in understanding Shares 101 Basics for retail investors not to forget that you are investing in actual businesses from a business perspective and not in share prices, which go up and down on a daily basis. (More about this later.)
From my point of view, shares are much less risky if they are bought for the long term. If you don’t ever have to cash the shares in in large quantities at particular times and you don’t depend on the dividends for income, then shares aren’t that risky. If you need the income on a regular basis to survive, and have to cash in shares at inconvenient times to buy other assets, then investing in shares becomes much more risky!
How to Lose your Shirt and Everything you Own
Shares are less risky if kept and if the dividends are reinvested. Shares are more risky if the money is needed.
Short selling is another high-risk practice that I also dislike intensely, because although it has some legitimate uses, it is also subject to abuse and market manipulation.
Currency speculation is also an incredibly risky practice.
None of the above, leveraging, short selling or currency speculation, should ever be contemplated by retail investors!
An Analogy with Horse Racing
When you engage with the share market you need to be clear headed and clear thinking. You need to have a clear strategy and a consistent approach. Don’t gamble on rumours. Don’t consult horoscopes. Don’t act on casual conversations with your peers.
A famous horse racing identity in Australia, ‘Dr Turf’, wrote a very humorous guide for racing punters in 1987. Dr Turf said that when most punters enter a racecourse their heads turn into pumpkins. Don’t put a pumpkin over your head, when deciding what to buy or sell. That’s all I ask.
Warren Buffett, the oracle of Omaha, who hasn’t heard of Warren Buffett one of the world’s most successful investors and richest people. I will deal with Warren Buffett and the Superinvestor’s approach to investment in detail in article 2. Warren Buffett is famous for his pithy statements, contrary approach to things and his excellent advice.
Perhaps his most pertinent advice for novice investors is to buy and hold forever (alluded to above).
Most professional advice in the share market is that you must trade. Financial professionals make money from the churn. They want you to buy and sell incessantly. (Trading regularly on the rise and fall of the market is gambling akin to horse racing.)
Warren Buffett says: The stock market is a device for transferring money from the impatient to the patient. This wisdom is something you will only begin to understand from experience.
Even starting out in Shares 101 Basics, Buffett is an important person to learn from. Buffettology, a new word, was coined by his daughter-in-law precisely for this learning.
I’ve said all I want to about property. Many people love it and make money renovating and trading up, but property is illiquid and the transaction costs are high.
4 Managed Investments and Indexed Funds
These are covered in Further Information.
It is rare that anyone acknowledges the role of luck in financial dealings. (I will in article 3).
Stock markets and shares do tend to follow a business cycle, as does property. These cycles can but usually don’t coincide. Also, unfortunately the timing of these cycles isn’t regular or predictable. Occasionally, however, one might be in the right place at the right time. This is called luck!
Unfortunately, the right place and the right time aren’t always recognisable. And, even when they are, you may not be able to take advantage. And worse, even if you can, it may not pan out. That is luck also! And, a lucky success is often defined only in retrospect. Most people are also quite reluctant relate their financial success to luck.
An anecdote about property might give you some idea of the role luck can play.
A colleague and I flew to Melbourne to conduct some real estate focus groups for a small boutique real estate agency, the client of a major advertising agency. This was at a time when Melbourne was being called unkindly ‘the rust belt’.
Over a weekend we did a crash course in Bayside real estate, at the end of which we attended the auction of a period carriage house conversion in St Kilda. The property went for $500,000, which we knew was a bargain and had we had the money at the time we might well have bought it ourselves. But, we didn’t have the money.
The property was resold less than 18 months later for $1.5 million. However, we did not know that the turnaround would be so quick in Melbourne. We might have had to wait for ten years.
With shares, one enters the market when it is the time in our lives to do so! We have no idea whether it is a good time or not. (Malcolm Gladwell covers why these issues are related to luck in his book Outliers: The Story of Success.) We can wait patiently over a few weeks or months and buy shares judiciously when the market drops. But, even if some pundit says that the stage of the market is so and so. He doesn’t really know.
It is good luck if you buy into the market, when it is just starting to rise steeply for the next ten years. And bad luck, when though the signs are promising, it remains in the doldrums for years or crashes. (Property is the same.)
The stock market is regularly in the doldrums for seven-year stretches, sometimes more, sometimes less, since 1929. Think of the following recessions 1960-61, 1974-75, 1980-82, 1990-91 in Australia. Then, the Vietnam War, the oil crisis, the 1987 stock market crash, the dot.com bubble — late 1990s to 2002, the GFC 2008, the Coronavirus pandemic 2020 and ongoing.
You can control for this with the share market by gradually building a portfolio over years.
6 Final Take Home
- If you don’t enjoy it, don’t do it.
- Buy stocks to hold forever. Sure you’ll buy and sell shares, you’ll probably make the same mistakes I did, but the over-riding goal is to build a solid portfolio for your retirement.
- Be patient!
The books mentioned here, two of them above, are all surprisingly Australian. I’ll get on to Warren Buffett and the international investment materials in the next article.
1 Richard FitzHerbert Blueprint for Investment: A Long Term Contrarian Approach 2nd Edition 1998
Dismissed with ‘Worth a read’ in the Australian Financial Review, 1998.
FitzHerbert is no longer in print and I’m not recommending it. It is the book I used as my reference guide to Australian investing and it was extremely useful to me at the time. I’m sure there are equally good contemporary guides in Australia, the UK and the USA you just need to find one. But, please be careful in looking, because there are also plenty of dogs out there that will confuse and mislead you.
2 John Rothfield Dr Turf’s Guide to better Punting 1987.
This is a gem if you are interested in horse racing. As well as being funny, it is incredibly accurate in its advice. Sadly, long out of print, but snap it up if you stumble across it in a second hand bookshop.
3 Scott Pape The Barefoot Investor 2016 and further editions is an essential read.
If you pay your bank too much for anything. If your credit card is maxed out, then you are not yet ready for serious investing until you clean up your finances.
It is a step-by-step cure-all, which is easy to follow for anyone with financial woes. And though it is entirely Australian focused the general advice is applicable anywhere. If your finances are a problem and you haven’t focused on eliminating the fees you pay to financial organisations, then read Scott Pape, before you begin investing in shares.
4 Malcolm Gladwell Outliers: The Story of Success 2008 (not Australian).
Gladwell is looking at high achievers like John D Rockefeller or Bill Gates and even professional hockey players. When they were born is critical to their achievements and is quite crucial to the type of luck I am talking about.
Key Words: shares, basics, stock market, ASX, CHESS, cash, property, interest rates, inflation, retail investors, mums and dads, self-managed superannuation funds, asset classes, liquid, illiquid, volatility, risk, returns, franking credits, negative gearing, term deposits, leverage, derivatives, margin loans, short selling, currency speculation, Warren Buffett, super investors, buy to hold forever, patience, trading, financial professionals, churn, portfolio, retirement, managed funds, index funds, luck, business cycles
Because this is a complex subject and some of the terms or ideas may be unfamiliar. I have given explanatory links throughout the text rather than at the end, which is my usual practice.
I have included additional information here that doesn’t really belong in the main text but may help round out your understanding of the issues. There are also other aspects to finance and investing that I haven’t covered, such as, income securities and convertible preference shares. These can be very valuable but do not really belong in a description of basics. Once you understand the basics and have practiced them, you can begin to discover other areas.
Managed Investments and Indexed Funds
Managed Investments or managed funds can be one form of investment for the retail investor, which leaves all the decisions and worry in the hands of ‘so called’ professional managers. Managed funds can be for local shares, international shares of various types, in bonds; they may be designed for growth or conservative investment. Indeed, they can be for almost anything that institutions can market to customers.
I’m not a fan of funds managed by financial institutions for the following reasons:
- They are managing my money, without my input and without risking their own money.
- The fees are often exorbitant.
- You can’t you control how your funds are used.
- You can’t assess whether the institution is dealing with you honestly, nor
- Whether their behaviour has changed during the course of your investment.
My experience in Australia gives two other reasons for caution.
- Recently, Australia had a Banking Royal Commission into the behaviour of banks and other financial institutions. In general, all behaved badly (beyond belief), often fraudulently and they treated their customers with deceit and dishonesty.
- Around the turn of the century, after diligent research and choosing a reputable financial advisor (don’t get me onto MER or hidden commissions). I invested in several funds for myself and for my mother. After ten years, I cancelled all the investments. My mother and I made excellent profits. But, I had no idea why some funds had performed well and others badly and I didn’t like it. I had no control (or come-back).
One type of managed fund that Warren Buffett strongly recommends for retail investors, and I agree though I don’t invest in them myself directly, are low-cost indexed funds.
If you want exposure to the share market, but without the effort and the decision-making, then indexed funds may be the way to go.
They are based on a fixed strategy, such as tracking a particular stock exchange index. The managers of such funds buy shares or invest automatically, in accord with an index or set of rules. The fund managers don’t actually manage, that is, they have no decisions to make. Hence the fees should be low. Nevertheless you need to stick to reputable funds. Vanguard (one of the initiators of such funds), for example, handles several index-type funds. But, you need to study the details before you invest.
The three topics below relate specifically to Australia, but may also be of interest to some overseas readers.
SMSFs in Australia
As a retail investor in Australia, if you are thinking of investing in shares or property towards retirement, then you should at least consider setting up an SMSF (self-managed superannuation fund) when you have a sufficient portfolio.
I think SMSFs are the way to go, because of the tax breaks, but you need to do the work to manage and set one up yourself (probably with the aid of an accountant). Please avoid the exorbitant fees charged by organisations, who would like to take the whole thing out of your hands (sharks).
SMSFs have grown dramatically in Australia in the twenty years since they have been regulated. In 2020, SMSFs in Australia represent 26% of superannuation assets.
Paul Keating (ex-Australian Prime Minister and Treasurer, who introduced the superannuation guarantee into Australia in 1992) in a 2013 talk said: At December 2011, total Australian super assets were weighted:
- 50% to equities
- 18% to fixed income
- 24% to cash and term deposits
- and the rest across other asset classes including property.
He was concerned about the volatility of investing so heavily in shares in Australia, perhaps another reason for really needing to understand the share market.
Franking Credits and Negative Gearing
Both give Australians big advantages in investing.
Franking credits or dividend imputation is an advantage in stock market investing in Australia. Other countries have similar schemes: in full Malta, New Zealand, or in part Canada, Korea, UK.
No other country has the outrageous provision introduced by the Howard Government in Australia of a cash refund from the Tax Office, once the tax deduction component has been used up. This is hugely advantageous to the wealthy. Dick Smith, an Australian entrepreneur, said he was embarrassed to receive $500,000 annually as a cash refund from the tax office because of his franking credits.
Negative gearing (as a tax deduction) and the lowered capital gains tax (on the profit of sale) another Howard government initiative are extremely advantageous to investors in the property market, as long as you have a stable and predictable income. They make investment in property much more attractive than it should be.
Negative gearing also distorts the property market in Australia and is particularly disadvantageous to first home buyers.
Both measures are costly to government and unduly benefit the wealthy, but it is almost impossible to wind them back. Small retail investors in Australia should understand them and benefit from them.
A Moan About A Bank
I can’t emphasise enough that leveraging your investment in shares to make more money is not only incredibly dangerous, it is stupid. Sure you may increase your short-term profits, but your downside is unlimited. You are likely to lose everything you own!
In 2007 some time before the GFC stock market crash in 2008, I received a letter from the Commonwealth bank (CBA) encouraging me to take out a margin loan to buy shares under the title: Retire Early with a Commsec Margin Loan. Accompanying the marketing letter was a postcard. The postcard was a picture of an incredibly boring office, on the back was a letter from a couple extolling the excitement and wonderful time they were experiencing in the Bahamas (or similar destination) and all because of taking out a Commonwealth margin loan to buy shares.
I was incredibly offended by such unconscionable behaviour on behalf of Australia’s largest bank and complained to Federal and State regulators to no effect. Nowadays, we know much more about the egregious behaviour of Australia’s big four banks. It was beginning to get out of hand even in 2007 and had been going on for a long time previously. But, the behaviour became even more shocking in recent years.
posted in Canberra