In this new series, we chart Kyle Caldwell’s journey to build his own equity portfolio.
Since leaving university eight years ago I have made a living writing about investing. By my best guess, during this time I have interviewed perhaps 100 fund managers, including some of the sharpest investor minds around.
Not every fund manager, of course, can consistently deliver market-beating performance; in fact, far from it. Fund management is ultimately a zero sum game and the majority of active funds fail to add value consistently. Unsurprisingly, therefore, some investors turn their noses up at the thought of handing cash over to a ‘professional’ when market-beating performance cannot be predicted in advance.
Those in this camp have three options, the first of which is to buy an index tracker or exchange traded fund. Doing so will ensure that they get exactly what it says on the tin – predictable index-like performance minus fees. The second option is to hand over their cash to a financial adviser, who will then in turn probably outsource the investment decision-making to a third party, known as a discretionary fund manager or wealth manager. The total cost of going down this route will typically be 2 to 3 per cent of your pot every year. But with the long-run average returns for the UK stock market (including dividends) at just over 5 per cent a year, some will be tempted to go for the third option: swotting up and attempting to take on the professionals at their own game.
As part of a new series aimed at investors looking to buy shares for the first time, I will be going on my own stock market journey and will be putting my own money on the line. I feel that I have built a decent grasp of the rationale and mechanics underpinning investment in collective funds and trusts, but the technicalities of buying individual equities are not my forte. To date, I have mainly bought investment trusts and that’s where the bulk of my Isa is invested today, but buying a direct equity is a different ball game.
So, first things first. It makes sense to start with a blank sheet and look at the practicalities involved in becoming a stock market investor; later in the series we’ll move on to devising an ‘investment checklist’, explaining the importance and different ways of valuing a business, looking at how to access international stocks and at the market tricks that can help protect or enhance returns, and outlining the bad habits that first-time stock market investors should avoid at all costs.
How to get started
In the 21st-century world of electronic trading, buying and selling shares is literally at the fingertips of anyone with an internet connection. Most private investors today enlist the services of a middleman – an investment broker such as Interactive Investor, our sister company – to access the stock market. Shares in the chosen companies are held electronically in a nominee account via the broker, rather than being issued as ‘old-fashioned’ paper certificates.
Shareholder meetings and perks
Your name, though, will not appear on the companies’ share registers. As a consequence, there’s a risk you may miss out on shareholder meetings or voting opportunities. Check with a broker before you sign on the dotted line, to see whether provisions will be in place. According to ShareSoc, the UK Individual Shareholders Society, brokers tend to appoint investors to vote as their proxy according to the number of shares they hold as the ‘beneficial owner’. These days such votes can be placed electronically via the broker ahead of the meeting, or can be cast in person if you wish to turn up. Documents such as the annual report may also be made available electronically by the broker. Another thing to check is whether you can access shareholder perks when they are offered.
Check the price is right
There are other factors to consider when weighing up the choice of broker, such as research materials and tools, website functionality, range of investments offered and quality of service. But, ultimately, the main consideration for most is one of cost.
When it comes to buying individual equities, there are two main charges to consider: the annual fee levied by the broker, and the cost of buying and selling shares. Some brokers will levy percentage charges, so that your payments increase as your pot grows, whereas others apply fixed fees, meaning everyone pays the same, regardless of portfolio size.
It is important that your broker choice reflects your behaviour as an investor. If you plan on being an active trader, switching holdings on a daily or weekly basis, then look at the trading charges. You should look for a broker that has ‘frequent trader’ fees, as trading costs will be lower. Typically, trading costs come in at around £10 per transaction. Those who view themselves more as ‘buy and hold’ investors should focus primarily on the annual broker charge.
Buying a share: bid-offer spread
Once your choice of broker has been decided upon, you need to get to grips with the practicalities of buying a share. This involves getting your head around the mechanics of the bid offer spread, which can at times leave you feeling short-changed.
The prices of shares on the stock exchange are set by market-makers, who spend their days trying to match buyers and sellers. Market-makers offer two prices for each share they are making a market in. The first is known as the bid price. This is the price they will pay people who want to sell the share. It can be compared to the process at an auction: you hold some shares you want to sell, and someone bids a price to take them off your hands.
The second price is known as the offer price. This is what you will have to pay to buy the share. The market-maker is simply saying: ‘I can offer you some shares at a certain price.’ It is the price that they want to sell the shares to you for.
In order for the market maker to make a profit from trading shares there is a difference between the selling (bid) price and the buying (offer) price. This is known as the bid-offer spread. This spread is usually very small for large companies in the FTSE 100, but can be quite big when trading the shares of very small companies.
When you are investing in shares, it is important to understand the bid-offer spread because it is a cost to you. The wider the bid-offer spread, the larger your initial reduction in value will be in buying a share.
The best way to understand all these terms is with a couple of examples. Let’s say you want to buy some shares in Tesco. In this example the offer price is 205.3p, whereas the bid price is 205.2p. The difference between the bid and the offer price – the spread – is 0.1p or 0.049 per cent. This is very small because a market maker can easily trade millions of Tesco shares during the day and make money from it. What this means in practice is that someone buying shares in Tesco for 205.3p and then selling them for 205.2p would lose 0.049 per cent on their investment.
Shares in smaller companies tend to have much higher bid-offer spreads. This is because there are not many buyers or sellers on a daily basis. The spread is bigger to give the market maker an incentive to trade the shares and make a profit from making a market in them. For very small companies, the spread can be huge. For example, iEnergizer, a support services company, had a bid offer spread of 9p or 12.3 per cent on 27 March. This means that the buyer of a share in the company would make an immediate loss of 12.3 per cent.
In addition, when buying shares there’s another charge to pay: UK stamp duty, which has a current rate of 0.5 per cent. There are also a couple of annual allowances to be aware of. Capital gains tax is the amount of tax investors pay on profits in excess of the annual allowance of £11,700. There’s also a tax to pay on dividend income of over £2,000. Tax shelters, such as Isas and pensions, should be utilised as a first port of call.
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