Share Investment: Profits Or Risks?

Investing in shares can be profitable, but it is also a risk. The main risk of investing is the possibility of losing money – you might not recoup your initial investment. There is also the risk of not achieving your expected returns over a particular time period. The outcome of any investment is uncertain due to the unpredictable nature of the market. However, the potential reward of investing in shares is that your money will increase in value above and beyond inflation.

Share price appreciation

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.

Share prices are typically driven by expectations of the corporation’s earnings, or profits. If revenue (current or projected future earnings) increases, a share of ownership in the company becomes more valuable, too.

The stock market has delivered generous returns to investors over time, but it also goes down, presenting investors with the possibility of both profits and losses. The longer your investment horizon, the greater the risk you can afford to take as you have more time to recover from market downturns.

If you intend to invest for a long period, such as over a 10-year time horizon, you can assume more risk as you’re less exposed to the day-to-day share price volatility. If your investment horizon is shorter, you’d probably want a lower-risk stock since you’d be more exposed to price fluctuations.

One way to manage the risk of investing in stocks is through diversification. Diversification means putting your money in a range of investments. That way, if one investment performs badly, it could be balanced out by others—spreading your risk.

Income from dividends

Dividends are a portion of a company's profits, distributed as payments to owners of stocks, mutual funds, or ETFs. They are a reward for shareholders who have invested in a company's equity, and they are issued by a company's board of directors at a scheduled frequency, such as monthly, quarterly, semi-annually, or annually. Dividends are usually paid in cash, but they can also be in the form of stock or property.

Dividends are a popular strategy for traditional investors as they provide a steady stream of income. The best dividends are usually issued by large companies with predictable profits, such as those in oil and gas, banking, basic materials, healthcare, pharmaceuticals, and utilities. Dividends of 6% or more are not uncommon for high-quality stocks.

Dividends are taxed differently depending on whether they are classified as qualified or ordinary. Ordinary dividends, also known as non-qualified dividends, are taxed at the higher ordinary income tax rate. Qualified dividends, on the other hand, are taxed at the lower long-term capital gains rate, which is generally more favourable than the ordinary income tax rate. To be considered a qualified dividend, specific criteria must be met, such as a 61-day holding period rule.

It is important to note that dividends are not an income or expense for a company. They do not impact a company's income or expenses in its financial statements and instead come out of shareholders' equity.

Risk and return

Investing in the stock market is inherently risky, and investors could lose their entire investment if a company goes bankrupt. However, the stock market has delivered generous returns to investors over time, and there are ways to mitigate risk.

Risk

The main risk of investing in the stock market is the possibility of losing money. Share prices can fall, even to zero, and investors may not get their money back if the company goes broke. The value of shares is volatile and influenced by various factors, such as the performance of the company, market corrections, economic issues, and broader stock market trends.

Return

Historically, the stock market has delivered generous returns to investors over time. There are two main ways to earn a return on investment from company shares: share price appreciation and income from dividends. Share price appreciation occurs when investors buy stocks and sell them at a higher price, profiting from the difference. Dividends are periodic payments made by companies to shareholders from their revenue.

Managing Risk

While it is impossible to eliminate investment risk, it can be managed through diversification. Diversification involves putting your money in a range of investments, so if one investment performs poorly, it can be balanced out by others. Mutual funds and exchange-traded funds (ETFs) are popular ways to achieve diversification.

Evaluating Risk Appetite

When deciding whether to invest in stocks, it is essential to evaluate your risk appetite. This involves considering your investment aims, horizon, and risk profile. If you have a long-term investment horizon, you can generally afford to take on more risk as you are less exposed to short-term price volatility. If you have a shorter investment horizon, you may want to opt for lower-risk stocks.

Diversification

Different types of assets tend to react differently to the same economic, political, or financial events. By combining unrelated asset types, or even by looking for assets that will react in opposite ways, you can spread your risk more widely. For example, if one type of asset in your portfolio produces losses, the gains experienced by other types can offset them.

• Asset variety: Include different types of assets in your portfolio, such as stocks, bonds, real estate, mutual funds, and ETFs. All of these asset types offer different levels of risk and return.
• Geographic diversification: Avoid restricting your investments to a single country or region. Investing in international markets can protect your portfolio against specific economic or political risks that affect a particular location.
• Industry diversification: Invest in different economic sectors, such as technology, healthcare, consumer goods, energy, and finance. Each industry reacts differently to market conditions.
• Maturity diversification: Invest in assets with a range of maturities. Include short-term investments that can provide liquidity, as well as long-term investments that typically offer higher yields.
• Reassessment and adjustment: Diversification requires regular re-evaluation and adjustment. Periodically re-evaluate the contents of your portfolio and make adjustments to ensure your investments remain aligned with your financial goals and risk tolerance level.

Liquidity

Types of Liquidity

There are two main types of liquidity:

• Market Liquidity: This refers to the efficiency of a market in facilitating the purchase and sale of assets. Markets with high liquidity, such as the stock market, allow assets to be traded quickly and at stable prices. The presence of a large number of buyers and sellers contributes to market liquidity.
• Accounting Liquidity: This type of liquidity focuses on the ability of individuals or companies to meet their financial obligations using liquid assets. It involves comparing liquid assets to current liabilities, which are financial obligations due within a year.

Measures of Liquidity

Several ratios are used to measure accounting liquidity, including:

• Current Ratio: This is the simplest measure, calculated by dividing current assets (those convertible to cash within a year) by current liabilities.
• Quick Ratio (Acid-Test Ratio): This ratio excludes inventories and other less liquid current assets. It is calculated as: (Cash + Short-Term Investments + Accounts Receivable) / Current Liabilities.
• Acid-Test Ratio (Variation): This variation of the quick ratio simply subtracts inventories from current assets: (Current Assets - Inventories) / Current Liabilities.
• Cash Ratio: The most stringent measure, focusing solely on cash and cash equivalents. It assesses an entity's ability to maintain solvency in an emergency. The formula is: Cash and Cash Equivalents / Current Liabilities.

Importance of Liquidity in Investing

Frequently asked questions