Beginner’s guide to investing in shares
Investing in shares is a great way to grow one’s wealth. But the world of investing can sometimes appear so intimidating and confusing that many people who could benefit from it simply decide not to get involved. By demystifying share investing and teaching you how it all works, it’s our hope that you’ll see it’s fairly simple and can lead to great rewards.
So, if you’ve decided that you want to start investing in shares, congratulations! There is no more reliable way to create long-term wealth than through ASX share investments.
What are shares?
So, what are shares and how does investing work?
Shares, also called equities, are like tiny pieces of a company. If you invest in shares of a company, you own a small piece of that company. And your shares are worth a proportion of that company’s value.
You can either own shares on your own or pool your money with other people in a fund. Funds are managed by a fund manager. If you invest in a fund, you won’t have to put in the work of deciding which specific shares to purchase.
When you purchase shares directly, you become a shareholder. This typically means that you have the ability to vote on some company decisions. You can’t do this if you own shares through a fund, though.
Shares are sold and bought on the Australian Securities Exchange (ASX).
Why is investing in shares a good decision?
This means that every $1,000 you invest in the ASX 200 could be worth more than $6,700 in 20 years, $17,400 in 30 years, and $45,000 in 40 years. And if your shares do better than the overall market average, your investments could grow even faster.
Let’s take this a step further. If you invest money repeatedly over your lifetime, relatively small sums could turn into millions. Let’s say that instead of investing $1,000 once, you invest $500 every month in perpetuity.
After 20 years, you could reasonably expect to have about $344,000. In 30 years, you could have investments worth nearly $1 million. In 40 years, $2.6 million. You get the idea.
You may have heard stories about older people who never made much money from their jobs but are sitting on millions. The share market is often how they got there.
Not only is it worth investing in the ASX 200 for the long term, it’s also worth investing sooner rather than later. The longer you wait, the more you’ll miss out on potential gains.
Ready to dive in?
This is a long post, so to help you navigate your way around, feel free to use the links below to jump to your area of interest. Or read all the way from top to bottom. The investment of your time will be well worth it (see what we did there?)…
Table of contents
- How much money do you need to invest in shares?
- Are you ready to start investing in shares?
- Understand your investment goals
- Opening your brokerage account
- Should you invest in individual shares or are funds the better option?
- How much of your money should be in shares?
- How to pick your first shares
- 7 things all great share investors should know
How much money do you need to invest in shares?
Despite the common misperception, you don’t need a tonne of money to get started investing in shares. Brokerage fees have dropped significantly in recent years, so it’s practical to buy your first individual share with just a few hundred dollars.
You are also spoiled for choice with a nice selection of exchange-traded funds (ETFs) (don’t worry, we’ll get to what those are later), so you can literally gain exposure to a group of shares (local or international) or commodities (like gold) with very little outlay.
In short, if you’re ready to start investing in shares, a lack of investable capital shouldn’t necessarily stand in your way.
Are you ready to start investing in shares?
All other factors being equal, the best time to start investing in shares is as soon as you can. Your money will never have more long-term compounding power than it does right now.
Having said that, there are a couple of financial tasks to do before you put any of your money into the share market. It’s important to get rid of your high-interest credit card debt and to establish an emergency fund, so you can be sure that your investment dollars can be put to work as effectively as possible.
Pay off high-interest debt
In nearly every set of circumstances, the best use of your cash is to pay down high-interest debt (rule of thumb: interest 10% or higher). For most, that means credit card debt.
It’s very easy to underestimate the power of compound interest combined with time.
A 20-year-old lucky enough to invest $10,000 and achieve the historical share market average of 10% returns per year would be a millionaire before age 70. That’s multiplying your money by 100!
Unfortunately, that maths works the same way in reverse. If you’re accruing 10% interest, $10,000 in credit card debt becomes $1,000,000 before age 70. At an all-too-common 20%, that dubious milestone is hit well before your 50th birthday.
Obviously, this doesn’t happen in practice. By making even the minimum payment on your credit card you will generally prevent your debt from snowballing out of control, but the mathematics sure are scary!
Ideas to help you pay off your credit card debt as fast as possible include transferring your debt to a card offering an interest-free period, or obtaining a personal loan to lower your interest expense.
Establish an emergency fund
Stuff happens – stuff that requires money to fix. (Think job loss, car transmission issues, medical bills, or anything else that Murphy or life throws your way.) If you don’t have that money on hand, you’ll have to improvise to make ends meet, which could mean patching over the problem with an expensive solution like a credit card (see above) or worse.
That’s why everyone should have an emergency fund – a cash hoard you can raid if unexpected expenses show up. Your emergency fund needs to be readily accessible in a high-yield savings account.
Don’t expect to make a killing on this investment. The interest on most savings accounts these days won’t even keep up with inflation – but the peace of mind an emergency fund brings is priceless.
How big should this essential investment be? Here are some basic guidelines:
Then your emergency fund should cover living expenses for…
Have no dependents relying on your income
3 to 6 months
Are the sole breadwinner or work in an unstable industry
6 to 12 months
Are retired and living on a fixed income
While those suggestions may seem excessive, following them will put you in a position to stay the course in your investments, no matter what unexpected expenses come your way. It’s better to have it and not need it than to need it and not have it.
Even beyond an emergency fund, because of the volatility of the share market, any money you might need in the next 5 years DOES NOT BELONG in the share market.
That money belongs in places like basic savings accounts, high-yield savings accounts, money market accounts and funds, term deposits and government bonds.
Keep in mind that one type of account may not best serve all of your short-term savings needs. For example, cash earmarked for a home loan deposit that you plan to make in a few years is ideal for a term deposit, while money for your kids’ school fees may be better off in a high-yield savings account.
We realise at this point your head might be spinning with all the choices. If it is, take a few minutes to read our guide to asset allocation. It slows things down and answers questions like, “Exactly what percentage of my money should I put into shares?”
Once you’ve deployed your funds for near-term needs, it’s time for the share market!
Understand your investment goals
Another important thing to do before you start investing is to get a general sense of ‘who you are’ as an investor. There are a few important questions to ask yourself, such as:
- Why are you investing?
- What is your risk tolerance?
- What is your investment priority?
- How much time do you want to spend on your investments?
Why are you investing?
Your reasons for investing can play a major role in your investment style, risk tolerance, and more.
For example, if you’re saving for retirement, you should be less inclined to take risks than someone who has a substantial nest egg in their superannuation account already and is simply investing to try to make some additional money. The same can be said if you are investing for a specific goal, such as to pay for your kids’ education.
What is your risk tolerance?
Assessing your risk tolerance is more of a personality question. Are you a risk-taker willing to ride out some turbulent moves in share prices to potentially achieve better long-term returns? Or, would large swings in the value of your portfolio make you nauseous?
There’s tremendous variety within the share market when it comes to risk. To name a couple of examples, a company like CSL Limited (ASX: CSL), which has a long track record of profitability, and a young but high-potential share like WiseTech Global Ltd (ASX: WTC), represent 2 different ends of the risk spectrum.
What is your priority?
This is another question that can help you choose share investments that are right for you. If your priority is to grow your wealth, for example, then you don’t need to focus on dividend-paying shares.
On the other hand, if you plan to rely on your share investments for income, you may want to focus on higher-paying investments only. This is even true if you decide that you’re best suited to invest in index funds.
For example, an investor whose main priority is long-term growth might choose an ETF like the Vanguard Diversified High Growth Index ETF (ASX: VDHG), which has a 90% allocation towards growth assets and 10% to income-generating assets.
On the other hand, an income-reliant investor might choose the Vanguard Australian Shares High Yield ETF (ASX: VHY), which aims for exposure to companies with higher forecast dividends relative to other ASX-listed companies. An investor who falls somewhere in the middle might choose the iShares Core S&P/ASX 200 ETF (ASX: IOZ), which tracks the ASX 200 index and charges a reasonable management fee of 0.09%.
How much time do you want to spend on investing?
This is the main question that will tell you whether you should buy individual shares or if you’d be better off focusing on ETFs and mutual funds. To be sure, there’s nothing wrong with the latter option. Index funds can ensure that you do as well as the overall market which, as we saw in the introduction, is quite good over time.
If you want to choose individual shares, we absolutely encourage you to do so. However, there’s a caveat. You need to commit enough time to thoroughly and effectively evaluate the shares before you buy them.
At a minimum, we’d suggest only investing in individual shares if you have at least a couple of hours each week to learn about investing and to evaluate potential investment opportunities.
Opening your brokerage account
A brokerage account is similar to a bank account, but it allows you to buy shares, bonds, mutual funds, and ETFs. There are several great online-based brokerages with lots of features to help you analyse shares, reasonable commission structures, and user-friendly trading platforms.
Read our article How to choose a brokerage to buy ASX shares to find out more.
Individual shares? Or are funds the better option?
Here’s the key point to help you decide: if you have the time, knowledge, and desire necessary to invest in individual shares the right way, then we absolutely encourage you to do it.
If not, there’s nothing wrong with building a portfolio of low-cost ETFs and mutual funds to take the share-picking challenge out of the equation.
In fact, the world’s most successful investor, Warren Buffett says the best way for the majority of investors to get exposure to the share market is through low-cost passive index funds.
With that in mind, if you decide that you’re better suited to investing in shares through funds, here are a few things you need to know.
Mutual funds vs ETFs
There are two main categories of funds you can use to invest in the share market — mutual funds and exchange-traded funds (ETFs).
A mutual fund is an investment vehicle that involves a bunch of investors pooling their money to invest for a common purpose.
For example, investors might contribute $100 million to a ‘large-cap growth’ mutual fund. The fund’s managers would then take that money and build a portfolio of shares that meet that description.
You can invest in a mutual fund through your broker, but this involves a set dollar amount and mutual fund transactions take place only once per day. In other words, if you choose to invest $5,000 in a certain mutual fund, you would place your order and the broker would fill it after the share market has closed for the day.
An ETF is a collection of securities listed under one ticker (stock code) on the ASX. They can be traded just like individual companies, in exactly the same way. They provide instant diversification and remove the need to select individual stocks yourself.
There are many different types, including industry ETFs that focus on a specific industry, such as mining; ethical ETFs that invest in businesses with defined values like sustainability; and international ETFs that invest in overseas securities. The simplest ETFs track a major index, like the ASX 200, which means your returns will mirror the ASX 200 as a whole.
ETFs are similar to mutual funds in some ways. Specifically, they are also a pool of investors’ money used for a common goal but they trade on major exchanges just like shares.
So, you would buy a certain number of shares in the ETF, not a fixed dollar amount. And ETFs trade throughout the day, so if you place an order, it will be executed at the current market price.
Active vs passive management
If you’re planning to invest in funds, it’s important to make the distinction between passively-managed index funds and actively-managed funds.
Index funds are simply designed to track an index and replicate its long-term returns. For example, an S&P/ASX 200 index fund invests in the largest 200 ASX stocks by market capitalisation that make up the index, and with the appropriate weights. If the ASX 200 increases by say, 10% in a given year, the fund should do the same.
Because they don’t require any stock-picking expertise, these funds don’t have to employ active managers. This keeps costs much lower, as we’ll get into shortly.
On the other hand, actively-managed funds hire investment managers to construct the portfolio. The big difference from an investor’s perspective is that index funds are designed to match the performance of a benchmark index. Actively-managed funds are designed to (hopefully) beat a benchmark index. The downside is that active management costs more.
To be clear, this doesn’t mean that if you invest in an actively-managed mutual fund that you will beat the market.
In fact, numerous studies have shown that the majority of actively-managed funds underperform the broader share market. Some actively-managed funds can be worth the cost, but be sure the fund has a well-established history of beating its benchmark index before investing your money in it.
As a final thought about funds, it’s important to know how much you’re paying. If you look at a quote of any mutual fund or ETF, you should see a number called the ‘expense ratio’, which tells you the fees you pay as a percentage of your investment each year.
For example, if you have $10,000 invested in a fund with a 1% expense ratio, you’ll pay $100 in investment fees this year.
There’s no set rule as to what’s too expensive. For index funds, anything in the 0%–0.25% range is quite normal, while we’d consider actively-managed funds with 0.5%–1% expense ratios to be reasonable.
How much of your money should be in shares?
First off, this refers to the amount of your invested money. Obviously, things like your emergency fund shouldn’t be in shares. So, it’s important to learn the basics of asset allocation. For beginners’ purposes, we can narrow this down into two basic categories – shares (equities) and bonds (fixed income).
It’s a smart idea for beginners to read through our guide to asset allocation, but for the time being, there’s one main idea you need to know. Shares have higher long-term return potential, but also have more short-term volatility.
Bonds, on the other hand, tend to generate lower returns over long time periods, but also tend to be less volatile.
Because of these traits, shares are better suited to younger investors while bonds are more in line with what most older investors need (that is, capital preservation in exchange for lower returns).
Here’s another important concept. All investors should have some combination of the two, with younger investors more stock-heavy and older investors more bond-oriented.
There’s no set-in-stone rule when it comes to asset allocation, but a useful guideline is that you can get a ballpark idea of your share allocation by subtracting your age from 110.
For example, if you are 38, this implies that you should have about 72% of your portfolio in shares, with the remaining 28% in bonds. As you get older, you’ll adjust your holdings accordingly.
How to pick your first shares
Before you start picking shares, it’s important to build up a ‘tool kit’ that will enable you to evaluate and compare shares in the right way. With that in mind, here are some of the basic terms, metrics, and other things to know that will make the process easier and more effective.
Basic investing terms to know
Before you can properly evaluate shares, you have to speak the language. Here are a few basic investment terms you should know that will help you better understand share quotes and market commentary.
- Bid/ask — When you read a share quote, you’ll generally see 3 prices. You’ll see the ‘last trade’ price, as well as two other prices, called the ‘bid’ and ‘ask’. The bid price is the highest price someone is currently willing to pay for a stock. The ask price is the lowest price someone is currently willing to sell a share for
- Market capitalisation — The combined value of a company’s common stock, calculated by multiplying the number of outstanding shares by the current share price
- EPS — Short for earnings per share. If a company earned a profit of $1,000,000 during a quarter and has 1,000,000 shares on issue, its EPS would be $1. This is important in several of the valuation metrics we’ll discuss in the next section
- Beta — This is a good metric to ensure shares fit within your particular risk tolerance. Beta is a measure of how reactive a share is to market movements. A share with a beta of 1 can be expected to generally move in line with the broader market. A beta of less than 1 indicates a share with lower volatility, while a beta greater than 1 indicates a higher-volatility share.
Basic investing metrics
There are dozens, if not hundreds, of potential investing metrics you could use to evaluate shares. Obviously, it’s not practical (or necessary) to go through all of them here.
However, there are some basic metrics that are easy to calculate and implement in your shares analysis that all investors should know.
- P/E ratio — The P/E, or price-to-earnings ratio, is the most commonly used valuation metric in investing. To calculate it, simply divide a company’s current share price by its last 12 months of earnings per share. A company that trades for $60 and earned $4 per share over the past year would have a P/E of 15. This is most useful for comparing companies with stable profitability that operate in the same industry
- PEG ratio — For rapidly growing companies, the P/E ratio isn’t always the best metric. The price-to-earnings-growth ratio, or PEG ratio, is a metric that accounts for the fact that companies grow at different rates. To calculate, divide the company’s P/E ratio by its annualised earnings growth rate. For example, a company with a P/E of 30 and a 15% annualised growth rate would have a PEG ratio of 2. A low number is usually better
- Payout ratio — This is a must-know metric for dividend investing. A payout ratio is a share’s annual dividend rate as a percentage of its earnings. For example, a share that pays 60 cents to shareholders each year and earned $1 last year would have a payout ratio of 60%. This can help you determine if a share’s dividend is sustainable or in trouble, and can show you if the company is prioritising reinvestment in the business (growth) or return of capital to shareholders
- Debt-to-EBITDA — It’s generally a good idea to avoid companies with excessive debt. While there’s no specific definition of what ‘too much debt’ means, the debt-to-earnings before interest, tax, depreciation, and amortisation (EBITDA) ratio can help you compare the debt burdens of companies to put things into perspective. You can find a company’s total debt on its latest balance sheet, and you can find its annual EBITDA on its income statement. Both documents can be found in the company’s latest financial reports).
Value stocks vs growth shares
There are two main types of shares you can invest in — value shares and growth shares.
Value shares are generally thought of as companies that trade for valuations less than the overall share market’s average, although that’s not a set-in-stone definition. The important point to know is that the goal of value investing is to find shares that are trading for substantial discounts to their intrinsic value.
Growth shares are generally defined as companies that are growing faster than the market’s average. The idea behind growth investing is to find shares that have the highest long-term potential relative to their current share price.
Things to look for when choosing your first shares
The key to successful investing is making informed trading decisions. You’ll want to research the financial health and growth prospects of the companies you’re interested in. Remember, it doesn’t so much matter where the shares have been but where they’re going.
Read each company’s last few annual reports and trading updates, look up research reports, go over annual reports, and see what the professional analysts are saying. (You can read about what some of them think at fool.com.au!)
One of the most important things to look for when investing are durable competitive advantages in a company’s business. This could mean a valuable brand name, proprietary technology, efficiency advantages, greater scale, or high barriers to entry. The idea is that these types of advantages can help preserve a company’s market share and pricing power, which is essential for a successful long-term investment
You also want to buy companies with a solid balance sheet and low debt. We already mentioned that it’s generally a good idea to avoid companies with lots of debt. The debt-to-EBITDA ratio, which was discussed earlier, can help you analyse a company’s debt burden.
Stay current with the Australian economy
You’ll want to stay up to date with Reserve Bank interest rate decisions, investor confidence levels, the performance of share markets both in Australia and around the world, government policy changes, exchange rates, and the overall health of the national economy.
All of these factors can influence the overall market.
Start with blue-chip companies
Blue-chip companies are well-established, large corporations. Their share prices tend to move slowly, but they can provide good dividends and are a great way to get acquainted with the world of investing.
7 things all great share investors should know
As much as we’d like to, we can’t give you all of the tools you’ll need to be a great share investor in a single article. Learning about investing is a lifelong process, and even the most successful investors in the world still make learning a priority.
Having said that, there are some concepts that you should know if your goal is to become an excellent investor. Here are 7 of the best lessons you can learn as you get started on your journey.
- Long-term investing is the best way to go
As we mentioned in the introduction, the share market has historically generated total returns in the 10% range for investors over long periods of time (think decades).
However, over shorter time periods, it’s another matter entirely. Shares – even those of ultra-stable companies – can fluctuate dramatically in the short term. We’ve seen that in recent times when the ASX 200 swung wildly along with wider global market volatility due to the COVID-19 pandemic. Trying to time the market’s near-term movement is almost always a losing battle.
The point? Long-term, buy-and-hold investing is the most reliable way to create wealth. Leave day trading and other short-term techniques to the professionals.
- Look at market crashes and corrections as opportunities
Nobody likes to watch the value of their investments plunge. Market crashes can be scary, but they are also the best long-term opportunities.
If you’re investing for the long run, the right way to look at share market corrections and crashes is like a sale at your favourite store. If you were shopping, and suddenly you heard an announcement that everything in the store was 25% off, would you panic and run away? Of course not! So, why would you avoid the share market when literally the same situation occurs?
- Don’t be afraid to sell if something changes
Even though long-term investing is the best way to own shares, that doesn’t mean that you have to hold every share you buy for decades, no matter what.
Legendary investor Warren Buffett once said, “All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies.”
Pay particular attention to the last part of the sentence. There are plenty of reasons to get rid of shares, especially if something changes with your overall investing thesis.
For example, if one of the reasons you bought a share was because you liked the management’s debt-averse approach, and the company starts borrowing excessively, it could be a good time to re-evaluate your position.
- Don’t invest in a business you don’t understand
It may be tempting to purchase shares of a hot, new company that’s got good media buzz. But until you have some experience, we recommend you steer clear of initial public offerings (IPOs), as the share price of a new company can be very volatile for an extended period. You’re much better off buying shares of companies that you know and trust, including those that you interact with during your daily life.
If you don’t understand biotech shares well, there shouldn’t be any of them in your portfolio. Warren Buffett doesn’t understand businesses with a lot of technology, so he tends to avoid them.
As a general rule, if we can’t clearly explain what a company does, how it makes money, and how it could grow in a few sentences, we won’t invest in it.
- Don’t follow the crowd
As human beings, our emotions often get the better of us, and that’s especially true in investing. When we see all of our friends making money on the latest ‘it’ stock, that’s when we want to throw our money in, too.
Conversely, when we see commentators on TV panicking and share prices falling, that’s when we’re inclined to sell before things get any worse.
It’s common knowledge that the main idea of investing is to buy low and sell high, but our instincts compel us to do the exact opposite. In fact, the majority of investors underperform the market over time, and being too reactionary to news and making emotional investing decisions is a big reason why.
- Know the difference between investing and speculating
There’s nothing wrong with taking a punt every now and then. It’s just important to be aware that’s what you’re doing and to limit your risk accordingly.
In other words, it’s important to know the difference between investing and speculating. If you’re buying a share and you can make the case that it’ll either triple or go to zero in the next few years, you’re speculating.
To be perfectly clear, speculating is an investing word for ‘gambling’. Don’t gamble with the money you need.
As an example, we generally recommend having about 5% of your portfolio’s value in speculative stocks at any given time, with the other 95% in shares that have a high probability of steady and continuous growth.
- Learning about investing is a lifelong process
We know we keep talking about Warren Buffett, but let’s face it, there isn’t anyone better to learn the rules of successful investing from.
On that note, many investors are often surprised when they find out how Buffett uses most of his time.
He doesn’t spend his workdays in meetings or on calls. Instead, he spends the bulk of his time sitting alone in his office and reading.
“Read 500 pages like this every day. That’s how knowledge works. It builds up, like compound interest,” Buffett says.
There is nobody on this planet who knows everything there is to know about share investing. If you want to become the best share investor you can be, you need to treat learning about investing as a lifelong process.
This article was last updated on 13 January, 2022. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and has recommended CSL Ltd. and WiseTech Global. The Motley Fool Australia owns shares of and has recommended WiseTech Global. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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