There are many benefits of investing in shares and we will explore how this common form of investment can be an effective way to make money.
Periodic income return
The income return represents periodic cash flows generated by the investment. These include dividends paid for shares and periodic interest paid for bonds. Stocks that pay dividends typically distribute them quarterly. Government bonds pay interest on a semi-annual basis and debentures pay interest monthly, quarterly, semi-annually or annually. Investors whose primary objective is to generate periodic income from their investments focus on the income return.
Capital gain
Price change is the increase or decrease in price of the share in relation to the purchase price or the market price in the previous time period. An appreciation in the price of the asset is called a capital gain while a price decline is called a capital loss. The prices of assets such as stocks, bonds and real estate fluctuate over time in response to a variety of factors such as economic news, industry conditions, company`s performance, political conditions, as well as speculation. While the investor expects a capital gain, there is no guarantee that the price will always increase in value. Those investors whose primary investment objective is capital appreciation focus on the price change component of return.
Measuring returns
The total rate of return of an investment can be measured in two ways: Rupee return and holding period return.
Rupee return
The rupee return is equal to the sum of the income and price change measured in the terms of the amount of rupees during a specific period of time.
Total Rupee Return = Income Return + Price Change
Example: You purchase a stock at Rs.80 last year. It paid a dividend of Rs.4 during last year. The current market price of the stock is Rs.100. What was the total rupee return to the investor last year?
Income return is the Rs.4 dividend. Price change is Rs.20, which represents the increase in price from the purchase price of Rs.80 the current price of Rs.100. Total Rupee Return + Rs.4 + Rs.20 = Rs.24
Holding period return
Holding period return is a very basic way to measure how much return you have obtained on a particular investment (HPR) .The sum of the income and capital gains generated during a specific period as a percentage of the initial purchase price or the beginning of the period price of the investment. The holding period return is given by the following equation.
Example: you purchased a stock at Rs.80 last year. It paid a dividend of Rs.4 during last year. The current market price of the stock is Rs.100. What was the holding period return to the investor last year?
Example: you purchased a stock at Rs.80 two years ago. It paid a dividend of Rs.4 in the first year and Rs.4.25 in the second year. The market price of the stock at the end of the first year was Rs.100. The current market price is Rs.120.75. What was the holding period return to the investor last year?
Voting right
Shareholders have a say in the affairs of the company. One of the ways they express themselves is by voting at the Annual and Extra-Ordinary General Meetings of the company. The board of directors need the ratification of shareholders before any major decision is taken. For instance, shareholders must give their consent before a company embarks on a public offer or a right issue. They also have the rights to sack erring directors. They do this by exercising their voting rights. Shareholders do not necessarily need to be physically present at the site of the company’s annual meeting in order to exercise their right to vote. It is common for shareholders to voice their vote through a proxy.
Right issues
A rights issue is an invitation to existing shareholders to purchase additional new shares in the company. More specifically, this type of issue gives existing shareholders securities called ‘rights’, which, well, give the shareholders the right to purchase new shares at a discount to the market price on a stated future date. Each shareholder is given the option to purchase a number of shares in proportion to the number of shares already held by the shareholder. For example, a right ratio of one-for-two means a shareholder can subscribe to one new share for each two shares already held by the shareholder. An investor owing 100 shares prior to the rights issue gets the right to subscribe to 50 new shares. This increases the firm’s number of shares outstanding.
Stock splits
Sometimes, companies split their shares into more shares. A stock split is where a company subdivides its outstanding shares so as to increase the number of shares. For example, one-for-two will create one new share for each two shares outstanding. A company with 100,000 shares will create new shares and as a result, the total number of shares outstanding increase to 150,000 shares. A shareholder who owned 100 shares will now own 150 shares worth the same. The company does not receive any funds and hence, there is no change in the value of the firm. The only change is that the company will transfer the value of the new shares from revenue reserves to share capital. However, since the firm has more shares now, the price per share will decline to reflect this.
Liquidity
Another benefit of investing in shares is that it is a liquid asset compared to some other financial instruments. The stocks traded in the market also have greater liquidity than other securities. This means that it can be easily converted into cash by selling the equities with other traders in the market because it is relatively easy to find buyers. Compare this to selling property, where you may have only one or two interested buyers.
Accessibility
Another advantage of investing in stocks is its accessibility. There are many stocks available in the market today. With proper research and analysis of the stocks and the companies that issued them, anybody with sufficient capital can acquire ownership of stocks.
Ease of diversification
Diversification is easier in a stock market. Diversification is simply not putting all your eggs in one basket. If you make smaller investment in various different companies, the likelihood that one of your investments fails means that it won’t have a great effect on your total investment. If you have all your eggs spread between a number of baskets (investments), you are more insulated from any possible downturns. You can get greater diversification though investing in different types of shares. Compare this form of diversification to property, where a large sum of money is placed in just one investment.
Availability of information
Information about particular companies, especially companies tracked by the S&P SL 20 Index is easily found. You will be able to access information through print and electronic media, stockbroker firms, research companies, etc., prior to making an informed decision.
Lucrative long-term performance
Over the long term, stocks have consistently provided better returns than most of the other types of investments (e.g. Treasury bills).
Further on, stocks can be an excellent choice for retirement vehicles, especially for those with a long time to retirement. The longer your time horizon, the more valuable stocks can be. A long time horizon will help to even out the inevitable ups and downs of the market.
The facts stated above indicate the benefits of investing in a stock market. However, there are a few factors investors should be vigilant about when investing if they are to maximize their profits.
Stocks are volatile investments. The price of a single stock can vary quite widely daily and the factors that cause these price fluctuations are in most cases beyond the control of the investor.
Don’t invest simply based on hearsay basis, even if the tip comes from a close associate. Take informed decisions.
Speculation is best for seasoned investors and it is best if new investors don’t attempt to speculate before they understand market dynamics.
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