The pros and cons of buying shares

If you’re looking to invest in shares you need to know some of the risks involved. Sure, you may be able to make more than you would by putting your money into a regular savings account. But you may also make a loss and could potentially lose the lot.

When you buy shares – as the name says – you buy a share in a company. Shares are also sometimes referred to as stocks. The hope is that the company will be successful and maybe the value of your shareholding will grow, which is known as a capital gain or capital growth. The hope too is that the company will be profitable and so you will get a share of that profit paid as a dividend for each share you hold.

So what are the pros and cons of buying shares, whether you are investing in the Australian sharemarket or buying shares on overseas markets?

Pro 1: You can make money in shares

Australian shares have outperformed many other investment options tracked over a 30 year period, from 1991 to 2021, according to investment company Vanguard Australia.

The company found Australian shares grew by an average 9.7% a year compared to 8.6% for Australian listed property, 8.3% for international shares and 7% for Australian bonds. Over the same period the consumer price index, a measure of inflation, rose by just 2.4% a year.

Look at a graph of the All Ords index (ASX: XAO) and you can see how it has grown over time. The index tracks the 500 largest companies listed on the Australian Securities Exchange (ASX) according to their market capitalisation.

For example, the All Ords was 1,582 in March 1992 and had risen to 7,323 in February 2022. That’s an increase of about 5,741, or about 362%.

The key thing here is time.

Rachel Waterhouse, CEO, Australian Shareholders’ Association (ASA), told Canstar: “All investors need to be aware that shares require a timeframe of a few years or more.”

If you're looking to make a quick profit in shares, you may well be disappointed. Keep in mind too that past performance is not a reliable indicator of future performance.

Con 1: You can lose money in shares

Look again at that chart of the All Ords (above) and you see there are times when share prices fall, sometimes very sharply (more on that later). That could happen to some or all of your shareholdings.

The challenge then is knowing whether to hold onto your shares in the hope things may recover, or to sell and take a loss. This is known as a capital loss. It’s also known as a paper loss.

“A paper loss is when the value of your shares purchased is less than you paid for them,” said Ms Waterhouse.

“The loss only materialises when you sell them.

“Knowing what type of investor you are will help [you] prepare for this experience. Will a sharp fall in share price cause you to sell before you think, or will it stop you selling until the share price gets above your buy price?”

If you invest in shares, you need to be prepared for the possibility that prices could fall. It can be a good idea to have a plan, and to know what level of losses in a particular company’s shareholding you are prepared to take. For example, CommSec suggested a 15% fall in share price as a possible trigger to sell.

If you continue to hold onto falling shares, you may end up with nothing. You could also lose out if a company goes into administration. Just ask shareholders in Virgin Australia, who got nothing when the airline was eventually sold off to United States-based private equity firm Bain Capital.

Pro 2: It’s easy to buy shares

There are two main ways to invest in shares. You can use a broker or you can sign up for one of the many online trading platforms available and do it yourself.

“A stockbroker comes at a higher cost and can provide you with general or personal advice,” said Ms Waterhouse.

“An online trading platform allows you to directly buy and sell shares at a lower cost.”

When choosing an online platform, her advice was to look carefully at what each offered, including:

• fee amount and structure
• ease of platform use
• ease of cash transfer
• trading limits.

You may also want to check out those picked by Canstar as award-winning online trading platforms. The ASX has some tips on how to find a broker.

Con 2: Make sure you have enough funds

Because it’s so easy to buy shares, you may be tempted to make a bid for something before you have enough funds in your share account to settle the deal. You usually have two business days after a bid is accepted before full payment is needed.

If you don’t have enough funds in your account to cover the bid and any fees, then you may find your transaction is suspended or even rejected. You may also be charged a penalty fee.

“It is important to be aware of the rules around transferring cash to settle purchases,” said Ms Waterhouse.

“If a broker allows trading before cash is transferred and there is some sort of glitch with the transfer of shares or timing of the transfer, shares may be sold to pay or part-pay settlement.”

The same may apply if you use an online trading platform.

So it’s a good idea to always check you have enough funds in your share account to cover the settlement, including any fees, before you make a bid for any shares.

Knowing which shares to buy is the next challenge.

Pro 3: Plenty of shares to choose from

The All Ords may track the top 500 companies on the ASX but there are more than 2,000 listed you could choose from. You may also want to look at markets overseas.

So what to look for when choosing where to invest?

Ms Waterhouse said you need to do your research to understand what a company you're interested in actually does. For example, what does the company make or what service does it provide, what’s its size, its history, its strategy for growth, the skill of the management and board members.

“Does the company make sense to you?” she said.

“An understanding of the company or industry may relate to your profession, industry or being a customer or your research.”

Be careful though when looking at a company’s financial history, especially its share price and dividend payments.

“Looking at the past performance is not a guide for future performance,” she said.

“Look for companies likely to do well over the long-term and historically, in a general sense, shares that have increased in value over time.”

Con 3: You can get overexposed to risk

It’s tempting to invest in companies that work in a particular industry or sector that interests you. But be careful not to be too invested in one sector.

You might want to consider some diversity in your investments. That way if one particular sector or industry runs into trouble and share prices there start to fall, that may not be the case in other sectors.

The ASX uses the Global Industry Classification Standard to split the listed companies into 11 sectors: energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, communication services, utilities and real estate.

You can see how each sector is performing over different time periods from the ASX’s homepage. You may have access to similar information if you use an online trading platform.

You don’t have to stick to the Australian sharemarket to diversify your investments.

“Many investors diversify their share portfolio through a selection of Australian and international shares across different sectors,” said Ms Waterhouse.

“An affordable way to access a sector or the international market is through an Exchange Traded Fund (ETF). You can buy and sell units in ETFs through a stockbroker or share trading platform, the same way you buy and sell shares.”

Compare Exchange Traded Funds (EFTs)

Pro 4: The benefits of growth vs dividend

Some share prices increase over time while others remain steady. Some pay regular dividends while others don’t.

So what should you look for?

“I personally look for great performing companies, followed by dividends that can be reinvested to build my portfolio over the long-term,” said Ms Waterhouse.

“What you look for will depend on your circumstances and timelines.”

This is something you should discuss with your broker if you use one. You may be wise to consider some other independent and professional financial advice.

It all comes back to timing, knowing how long you aim to invest, and what your investment goals are.

Con 4: The sharemarket might crash

As we said earlier, sharemarkets can suffer big falls from time to time, known as a share market crash.

There are many reasons why a sharemarket may crash but predicting a fall is difficult even for the wisest of investors.

For example, many sharemarkets around the world took a fall when Russia invaded Ukraine in February, but they took a greater fall in January that was seen by many financial observers as a ‘market correction’ – when investors feel some shares have been overvalued.

Read more: 4 stock market crashes and what caused them

Over time, sharemarkets do have a history of recovery, but again, that can take time and there are no guarantees that all individual share prices will rise.

“First time investors need to be prepared that they are taking a risk with shares and realise that share prices will go up and will go down,” said Ms Waterhouse.

“In the past they have reversed, but sometimes it takes months or years to go above a previous high.”

For example, it took 12 years for the All Ords to pass its previous high point set before the Global Financial Crisis hit Australian share prices in 2008.

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Cover image source: insta_photos/Shutterstock.com