In my ultimate guide to investing in shares & the stock market and our explainer ‘what are shares?’, I briefly address why shares are good investments:
- High expected returns
- Tax efficiency
- Liquidity
- Narrow pricing spreads
- Regulation
- Hands-free pricing
- Loyalty & novelty
In this article, I will explore these reasons in detail to help explain why equities are the preferred investment choice for so many personal investors and what to invest in to receive reasonable market returns. This is not financial advice, therefore you’ll need to perform your own research before investing.
High expected returns
The average historical return you might see quoted in the financial media for shares is roughly 8% per annum.
This is a nominal return, meaning that does not reflect inflation. While a share might be worth 8% more, it would not be able to purchase 8% more goods, because prices will have also risen during the same period.
In my free investing courses, I usually quote a ‘real return’ of 5-6% which provides a more realistic picture because it includes inflation. This doesn’t assume that you’ll pick the best companies to invest in, but rather you invest in a good spread of funds which return something close to average.
Many groups, from financial advisers to print journalism expect that this long term average will continue into the future – but this is only an assumption. The late fund manager John Bogle, writing for the Financial Times, did question it.
Despite some criticism, this figure is widely accepted and is used to compare the returns of shares with other asset classes, such as bonds, cash and investing in property.
This comparison is favourable for stocks & shares, as bonds, cash and property have returned far less in the past.
This is the reason why shares are often the dominant asset used to build an investment portfolio. To maximise the expected return of a portfolio, it is natural to choose an asset allocation which places it front and centre to take advantage of those high numbers.
Tax efficiency
Shares offer investors the opportunity to pick investments that distribute their profits in different ways.
This allows an investor to avoid tax when investing by choosing the investment types that complement their personal tax position.
In the UK, the capital gains tax (20%/28%) paid by high earners is much lower than the rate of tax they would pay on income.
Tax rates and rules are complex and can change, so I urge you to perform your own research on the website of UK’s HMRC or your local tax authority.
One clever strategy is to focus investments in companies that reinvest their profits, rather than pay profits out as dividend income. This way, the investor can sell shares and be taxed on the capital gain, rather than be taxed on income from the shares. If possible, the shares might be held forever after, meaning no capital gain ever arises (until end of life).
Liquidity
Shares in large companies are traded heavily while the markets are open. On the day of writing, 263 million Lloyds Banking Group plc shares changed hands.
This means that we can say the market is very ‘liquid’. In such conditions, any small seller can obtain a fair price for their shares almost instantly. This means that unlike property, a share investor can convert their shares into cash within a week. This is useful if an emergency occurs which requires a sudden change of plan.
If we compare this against the corporate debt issued by small companies; trading these bonds may not be as instantaneous. Placing a large sell order in a small market may cause the market price to move against you before a deal is agreed. This occurs where your stockbroker initially accepts the best bids but then is forced to accept lower bids to ensure the full quantity is sold.
Narrow pricing spread
The high volume of a stock market allows the professional middlemen traders to quote buy and sell prices that are very close together. This is known as a ‘narrow spread’. These traders are happy buying for only slightly lower than their sale price, as they are confident will be able to get rid of the shares very quickly and lock in the profit.
A narrow spread means that sellers are receiving the highest price for their asset, and buyers are not overcharged when they purchase the same asset from the middleman.
In slow or opaque markets, traders need to offer wide spreads (less competitive prices), to protect themselves against an adverse price movement while they patiently hold the investment while waiting for the next buyer to emerge. The price to buy might be £105, and the price to sell might be £100. A wide pricing spread like this means that any investor makes a 5% loss upon purchase, as the market value of their shares will fall to the selling price.
Regulation
In mainstream share markets, the bid-offer spread is less than 1%, which effectively means that share buyers have reduced investment costs compared to other investment types.
Recognised stock exchanges such as the London Stock Exchange and New York Stock Exchange are heavily regulated.
This implies that the conduct of market participants and the conduct of investment providers is better than for unregulated investments such as land and forestry, which sometimes turn out to be online investment scams.
Hands-free pricing
The large companies listed on the main exchanges are scrutinised by investment bank analysts, journalists, fund managers and regulators. This helps disseminate information about the company into the public sphere.
This information shapes the opinion of traders and impacts the pricing of the shares. Trades nudge the share price in the direction towards the true value indicated by the latest available information.
For example, if a hedge fund manager learns of a potential fraud that has occurred at Coca Cola, they may sell their shares in the company. This selling activity will push the price down – closer to the value it ‘should’ be.
As a new investor – do you need to understand the fraud to be able to get a fair price? Not at all – the price has moved lower as soon as the news began to affect trading. You didn’t need to haggle – it’s hands-free pricing!
This process ensures that shares are priced accurately. Exactly how accurate is a topic of much academic debate. What is clear, however, is that public scrutiny does mean that shares are priced more competitively than many ‘off-market’ investments.
For example, consider an investment in art or wine. If you visited an art dealer – how would you be able to conclude whether the price of a particular watercolour painting is reflective of its underlying value, and is consistent with the broader market? You would need an impressive level of expertise to make a buying decision.
Loyalty & novelty
It’s a secondary point, but it’s worth highlighting that shares are also popular because they’re more desirable and interesting than a bank account.
Superfans of companies which inspire them (such as Tesla Inc or a football team) get a thrill from holding shares in them. This is for sentimental reasons rather than for investment purposes.
It is also exciting to think that by purchasing shares in Land Securities plc, for example, you are purchasing a fraction of the famous lights of Piccadilly Circus.
Enjoying this article? To read more about stocks & shares, check out our ranking of the best stocks & shares books.
