A Stock Market Investment Guide for Beginners: Share Categories Explained
Less than a month remains until the end of the current tax year and that means the rush to use up as much as possible of ISA and SIPP allowances. Every year is for some the first year of contributing into an ISA or SIPP. While it’s possibly to pay cash into a SIPPs, the vast majority of cash paid into self-invested pensions wrappers goes into investment products.
ISAs holdings are more mixed. While Cash ISAs opened last year saw a plunge in popularity, dropping to 8.5 million for the 2017/18 from 10.1 million the previous year, they are still the most common format in terms of number of accounts. Stocks and Shares ISAs are rising quickly in popularity though. HMRC data shows over 2.5 million Brits invested into stocks and shares ISAs in the last tax year. Also, while there were almost 6 million more Cash ISAs than Stocks and Shares ISAs last year, the value held in Investment ISAs surpassed that in Cash ISAs for the first time in 2016/17. Brits poured £315 billion into investments compared to £270 billion held in Cash.
And it proved to be a smart move by the UK as stock markets hit record highs. However, last year wasn’t a one off. The chart below, based on data from Fidelity, shows how stock market investments have beaten cash savings since 1999.
Over the coming tax year, the best Cash ISA returns won’t even beat inflation, which is forecast for 2.2%. Cash savers will finish the year poorer despite interest being protected from the tax man if held in an ISA wrapper.
However, Stocks and Shares ISAs aren’t always the most suitable option despite average stock market returns historically outperforming cash savings significantly. Because stock markets typically move in cycles, while average returns are around 5%, some years can see a portfolio take significant losses. No one knows exactly when a stock market downturn might happen, and there are plenty who believe the next may be around the corner. As such, Stocks and Shares ISAs are advisable for those with a longer term horizon of at least 5 years. If you think you might want to access your savings earlier than that, it is better to hold them in a Cash ISA even if inflation will erode purchasing power. If there is a stock market downturn, you need to be able to wait for the recovery to come around and in the worst case scenario that has taken as long as several years.
If you are investing with a 5 years plus horizon in mind, a Stocks and Shares ISA, or SIPP if investing for retirement, will almost certainly prove to be the better option. If you’re a complete beginner, and don’t want to fork out for qualified advice from a regulated IFA (Independent Financial Advisor) you should spend some time educating yourself on the basics of stock market investment. One of the most important things to get your head around is that company shares fall into different categories and as well as choosing shares in companies that do well, it is important to create a portfolio with the right balance of share types. Even the best professional investors don’t get all their share picks right and you shouldn’t expect to either. But if you have the right mix in your portfolio it should be able to absorb the impact of the inevitable misses and still deliver solid returns.
The best way to do that is to invest in different categories of shares. Shares can be broken down into three main categories, though some can potentially straddle two or even three of these categories. Nonetheless, in the majority of cases it is likely for each company’s shares you buy you classify them as belonging to one of these categories as more dominant than the others.
Income shares are those that belong to big, established companies that have finished their growth cycle. That doesn’t mean the company can’t still grow but it won’t, or is very unlikely to do so, at a fast pace. Because these big companies are well established, generate significant revenue but are not growing quickly anymore, they can afford to return a significant percentage of their profits to shareholders in the form of dividends. In fact, they have to, because slower growth means their share price is unlikely to rise significantly so to make their shares attractive they have to offer a return on investment in another way – dividends. This kind of company is often referred to as a ‘blue chip’.
Companies that consistently pay out strong dividends can come from any sector as big, established companies are not only found in specific sectors. However, that said, there are particular sectors that naturally lend themselves to creating companies that become income stocks. Companies whose business is not in producing goods or offering services that are cyclical and rely on a good economic climate are usually the most reliable income stocks. Utilities, telecoms and staple consumer goods (basic foodstuffs and domestic products) are the sectors that produce the most companies whose shares can be considered income shares. That’s because regardless of the economic environment we still use electricity, gas and water, still need our telephone and internet connection and still need to eat.
Growth stocks belong to companies which are growing quickly. Because these companies are expanding at an aggressive pace, they reinvest most of their profits into further growth. This could be through internal expansion or through acquiring other companies. This means their value will expand quickly with growing revenues and market share if things go well. However, it also increases the risk factor because mistakes that negatively impact the company’s financial health can be made during expansion decisions. Something that seemed like a good idea to the company’s management and board at the time may turn out to have been misjudged.
Growth companies can be large, medium and small caps. As a rule of thumb, the smaller the company the greater the growth potential but the higher the risk. If a big company makes an investment mistake but the business is generally doing well, like Alphabet’s Google Glasses flop, it won’t have such a big impact on overall revenues. A smaller company will be much more negatively impacted if it puts significant resources into a flop.
The big tech companies can fall into both the income and growth categories. The likes of Alphabet (Google owner), Apple, Amazon and Facebook are among the biggest companies in the world but are still growing fast. While a lot of their profits go back into expansion, they generate big enough revenues to return a decent proportion back to shareholders. They are, essentially growth shares and their share value is more volatile than would be typical of real income shares. However, they still pay dividends, though their value is also more volatile than would be expected of real income stocks.
Value stocks can be both growth or income shares. This category is companies that for one reason or another have been significantly undervalued by the market. This can be for a number of reasons. There may have been a scandal around the company or a period of poor performance. Often companies move past those kind of issues and are again good businesses before investors forgive previous problems. Or, they may be in a sector that has had a rough patch and been sold off. Some companies may have been less affected than others but be ‘the baby thrown out with the bath water’ as institutional investors sold off the sector as a whole. This is a window of opportunity for canny stock market investors to pick up a bargain before the rest of the market follows.
Balancing a Share Portfolio
A share, or stock market, portfolio should contain a mix of these different share categories. What the best weighting is will depend on your time horizon. If you are a beginner investor with your first Stocks and Shares ISA or just starting a SIPP, the chances are time is on your side. In this case, the larger allocation of a portfolio should be dedicated to Growth and Value share categories. It is still important to have a good 30% or 40% in Income Shares as they provide diversification and stability during market corrections. However, your Growth Shares should have time to recover before you need to cash in your investments if markets hit a downturn or more serious crash.
Most of your Growth Shares allocation should also go to bigger companies. Medium and small cap Growth Shares are at greater risk of hitting a more permanent downward spiral their share price may never recover from if things go awry. However, if you have time on your side, a 10% allocation to riskier Growth Shares can really help power your overall returns if you pick enough of them well. And if you don’t, you should have enough time to recover relatively minor losses if the overall weighting in your portfolio is modest.
Not putting all your eggs in one basket in terms of geography is also a good idea. The economies of different parts of the world do better at different times and diversifying risk is always a good idea. Especially at the moment, with Brexit uncertainty, diversifying a significant part of a stock market portfolio out of the UK isn’t a bad idea. Last year the US stock markets and those in Europe and much of Asia, particularly Japan, significantly outperformed the London Stock Exchange. There’s a good chance that over the next few years while the future of the British economy becomes clearer, that will continue to be the case.
As a beginner investor, it is also probably wisest to opt for funds rather than picking companies yourself. ETFs are passive funds that track and index, which are made up of lots of companies grouped in a particular way. They are much cheaper than actively managed funds in terms of fees, and can charge as little as 0.1% a year. For example, a FTSE 100 ETF will hold shares from all of the companies in the FTSE 100, the biggest 100 companies on the London Stock Exchange. There are also ETFs that track sectors such as utilities or telecoms for Income Shares, or Tech Companies for Growth Shares and you can buy ETFs that track indices from different geographies.
For more specific groupings of companies, look for actively managed funds with low fees that invest in, for example, small cap Growth Shares, medium cap Value Shares. These also exist with different geographical focuses.
If you are keen to learn how to assess company shares yourself, you can always put most of your portfolio into funds, to lower the risk of making poor decisions due to inexperience, and set aside a portion for your own picks. As you become more experienced and consistent in picking individual companies to invest in well, you can gradually increase this weighting in your portfolio.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.