How Risky Are Shares As Investments?
Understanding the nature of risk is fundamental in investment management. Shares form a major part of most growth portfolios. They deliver the potential for capital growth and income in the form of dividends. But are they riskier than other types of assets? In this post, I look at a few of the factors potential equity investors should consider before jumping in.
What Are Shares?
Ordinary shares represent ownership of the company. Larger companies sell their shares to the general public and they can be traded on the stock market. This enables an investor to sell their holding when they want to.
Shares have a face value, for example, £1. However, the price at which they trade on the stock market will depend on many factors. Such as the current economic situation, factors influencing the sector in which the company operates and the success of the business itself.
What Are The Benefits of Owning Shares?
As share ownership represents partial ownership of the business, shareholders are entitled to a share of the business profits. This may be in the form of an income payment (dividend) or through growth in the value of the shares. Dividends are not guaranteed. Some companies do not pay any dividends. They reinvest profits to grow the capital value of the company. Others have a long history of regular payments.
Are Shares Risky?
If you own just one company’s shares, your fortunes will depend on the success or failure of that company. If the company goes under, then as an ordinary shareholder you will probably lose all you have invested. Whilst investing in just one company’s share is risky, over the long term investing widely in shares has been one of the best ways to invest. The following table shows the average annual returns on some main indexes over the last 10 years:
These numbers hide some important facts. The S&P 500 contains 500 of the largest companies in the USA. Each quarter the index constituents are checked to make sure they still qualify for inclusion. If they do not then they are removed and another company is included. Therefore the companies which made up the index in 2010 are not the same ones as in 2020. Therefore tracking an index like the S&P500 ensures you are always investing in the winners.
Another important fact is the returns are not consistent. Some years returns are negative. See the chart below: