The largest single allocation in Anglo-Saxon private client portfolios has traditionally been to equities (in Europe, bonds have proved more popular, due a range of factors, such as less developed equity markets). This is understandable, given that according to finance theory, equities generate higher returns over the long term than less risky assets, such as bonds and cash. Research by the London Business School and Credit Suisse shows that from 1900 to 2015 for a global index of 23 nations (measured in US dollar terms), equities delivered a real return of 5.0 percent per year. This compared to a real return of 1.8 percent per year for bonds. The same study predicts that, based on an analysis of the three great crises of the 1890s, 1930s and since 2008/09, over the next decade, real bond returns will be close to zero, with real equity returns close to four to six percent per annum.
Nevertheless, in exchange for gaining a potentially higher return over the longer term, you need to accept an increased risk of losing capital, particularly over the short term. For example, the financial crisis of 2008 led to global markets recording record falls, including the FTSE having its worst year to that point and dropping by 31.3 percent. Since the crisis there have been other periods of volatility, including the start of 2016.
What are equities?
Companies can raise money through the issuance of shares on a stock exchange. By buying shares in a company, you gain a stake in the business, but also carry the risk of losing part or all of your investment. Shareholders are last in the queue when assets are distributed in the event of a company going out of business. This is an extreme possibility, of course, and the risk of investment losses depends on the company with which you invest.
You may receive distributions from the company, in the form of dividends paid out of its profits or share buybacks. The greater the profits of the company, the more scope they have for paying dividends.
Shareholders can also achieve a return on their initial investment through an increase in the share price. The price is determined by the demand for the company's shares. Demand is driven by factors such as cash flow, earnings growth, profits and the market outlook. There are different types of shares that you can own. Investors usually buy ordinary shares in a company, which allow them to vote on motions at its annual general meetings (AGMs) and extraordinary general meetings (EGMs). There are also non-voting shares.
Another variety is preference shares. Holders of such shares are preferred because they rank before ordinary shareholders in gaining their share of the business. Preference dividends are paid before ordinary dividends and preference shareholders will receive their share of assets before ordinary shareholders, if the company is wound up.
Preference dividends, however, are likely to be fixed and will often be repaid at a pre-determined date. It makes them more predictable and less risky than ordinary shares, but it also excludes them from most of the capital growth ordinary shareholders can achieve.
Warrants usually give shareholders the right, but not the obligation, to buy new shares in a company, at a fixed price and on a fixed date. Simplistically, evaluating whether warrants offer good value is determined by how much the shares must rise in value for the warrant investor to recover his money and make a profit.
As with all asset classes, equities cannot be regarded as a homogeneous group, when viewing their risk reward characteristics. Most UK investors concentrate on UK equities. This is understandable, given that you are more likely to invest in companies with which you are familiar. There is also no currency risk when investing in the UK for sterling investors.
Small and mid cap stocks offer the potential for delivering higher returns over the long term than large caps. This is because generally they are younger companies in a faster growth phase than large caps, which are usually mature companies. Small cap stocks are also generally less well researched than the large cap end of the market. This means there is potential for more mis-pricing and greater investment opportunities.
There is increased risk, however, with investing in small cap stocks, as they are usually more vulnerable to cyclical downturns, by having less capital and having a focus on fewer markets. Liquidity can also be an issue. If you want to redeem investments, particularly when demand for shares is low, it can be more difficult than from large caps.
Despite emerging markets not recording the high levels of growth as seen in the recent past, many professionals argue that they still offer higher returns than stock exchanges in developed countries such as the UK, US, Western Europe and Japan. By their very definition, emerging markets are at an earlier stage of development, have growing populations, growing consumer markets and lower costs of production. Emerging markets also benefit from being less well researched than their developed counterparts. Therefore, over the long term, you may want to hold larger proportions of small cap and emerging market equities, if you are looking for capital growth.
Emerging markets are subject to greater risks than stocks in developed markets, however. These include lower levels of transparency and corporate governance, vulnerability to cyclical downturns and political volatility. These risks, however, can vary significantly over time.
There are a number of ways in which you or your fund managers can select equities. These include focusing on the fundamental factors of each company through analysing, for example, earnings growth, cash flow and prospects for future profits. Alternatively, fund managers may choose themes, sectors or stocks, by reviewing the macro economic outlook and deciding which companies will benefit from the expected environment. Typically, many managers use a mix of both of these approaches.
There are a multitude of investment approaches used by managers in analysing the fundamental factors of stocks. Managers may focus on companies that will grow faster than the average in the stock market. To gain greater value, managers may seek companies whose share price does not reflect the potential for faster than average growth. Other managers choose companies that pay a high dividend yield, or whose dividend is increasing. A dividend yield is the amount of a company's profit that is distributed as a proportion of the value of the company.
It is argued that equity income is a lower risk investment approach than focusing on growth companies. This is because if the stock market falls in value, then the relatively high dividends will still provide you with an income. It is also said they instil discipline into companies management and reinvested dividends account for a higher proportion of total returns than capital growth over the long term. The potential downside is that these stocks may deliver lower capital growth over the long term.
Value managers try to select stocks that are inexpensive on various measures, such as trading at relatively low prices compared to their earnings. This is normally a result of the company being over-looked, or out of favour. Value fund managers may seek companies that are in a turnaround situation, or are in a sector that they hope will return to favour. The company turnaround may be prompted by a restructuring, new management, the launch of new products, or a change in the market environment.
Within these general investment approaches, fund managers have different ways of interpreting economic and company information, to decide which stocks to buy and sell.
You may also choose to invest passively, rather than actively. This means investing in index tracker funds, or exchange traded funds. Their performance is linked directly with the underlying index. With this approach, you are not taking an active bet against the stock market. If you choose an active fund manager, you risk potentially suffering a lower return than the index. Some investors prefer to invest passively in those markets where it is relatively harder to add value through active management, such as US and UK large caps, and thus save on relatively higher active management fees.
The benefit of these different investment approaches will vary over time, depending on the economic conditions. This is because share prices are also driven by anticipated economic growth and how this will translate into rising profits and dividends. When the economy is growing strongly and confidence in future economic growth is high, investors are generally willing to pay higher multiples of profits and accept lower dividend yields than would normally be the case because they believe future growth in profits and dividends will rapidly restore these multiples and yields to normal levels.
When economic growth slows, investors become concerned about future levels of profits and dividends, so may only invest if they are able to do so on the basis of below average price earnings ratios and above average dividend yields.
Stock markets, however, tend to both over-shoot and under-shoot. When investors become over-optimistic, share prices generally run too far ahead of the progress of the economy. Eventually, this must be corrected by a period of stagnation in share prices while the economy catches up, or by a fall in share prices.
Conversely, negative investor sentiment becomes self-fulfilling and pushes share prices down too far. Markets recover usually when least expected and sentiment has reached its lowest point. The share prices can then rise quickly over a short period of time.
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