How to Invest: Capital Gain, Dividend Income, Equity Securities (Shares), Debt securities (Bonds)

The basic idea behind investment is simple – use your money to make more money. The money you invest in securities (shares issued by companies, debt securities and other investment units) is called "capital" and the money created is the "return on investment". With investment in shares, the return comes in two forms – capital gain and dividend income.

Capital Gain
Capital gain comes from increasing share prices. When investors buy shares, they want the price of those shares in the market to be higher in the future. The higher the future prices, the bigger the capital gain for investors. Capital gain can occur rapidly - in days or even hours when share prices are volatile - or slowly.

Prices rise for many reasons but most fundamentally they rise because the outlook for a company's future profitability is improving. The biggest and most obtainable capital gains come from the shares of companies that grow and increase their profits over time.

Capital losses occur too, and sometimes very rapidly. When a company's profitability is declining or its outlook is poor, the share price will probably fall and shareholders lose.

Capital gains become a cash return on investment when investors sell their shares - they get back their capital plus an amount accrued because of the higher selling price.

Dividend Income
Companies often pay dividends out of their profits. Dividends are a means of sharing the money made by companies with their owners. Just as property owners receive return in the form of rent from their tenants, share owners receive dividends as regular income.

Shareholders in many companies receive dividends twice a year. New Zealand has one of the highest levels of return from dividends in the world.

When the amount paid out is high, dividends can be a big part of total investment returns since companies are retaining less money to reinvest in the business to grow potential future profits. On the other hand, some companies pay no dividends and keep profits to help fund growth in their business.

Equity Securities (Shares)
A share is a piece of ownership in a company. Buying shares in a company makes you a partial owner of that company. The more shares you buy, the bigger your ownership stake becomes and the more say you can have in how the company is run.

Along with ownership, a share gives you the right to vote at company general meetings and have a say in how the company is run - one vote for every share you own. However one of the realities of the sharemarket is that individual investors rarely get to own enough shares to be able to alone exert any significant influence over a company - that's usually for big institutional shareholders. Consequently, it is important to carefully research the competence of company management before you buy shares. The best measure of that may be the company's ability to consistently produce profits over time.

Debt securities (Bonds)
Debt securities can be used to diversify your portfolio and provide a steady return stream. They represent an amount of money lent to a company or other entity, such as the Government.

When a company or other entity issues debt securities it borrows money from the buyers of the securities, who become the lenders. Holders of debt securities receive returns in the form of regular interest payments ("coupons") from the borrower. They also get their original money back at a pre-defined date - the "maturity date" of the debt security.

How are shares valued?

Company Profits
Or more precisely expected future profits - are the fundamental indicator of share prices. Companies must report their profits at least twice a year and investors pore over these numbers - often expressed as earnings per share (EPS) - trying to gauge a company's present health and future potential. With any company, there will always be different views on future profits and all the factors that make its business successful or not. Share prices should reflect the combination of all such competing views at a particular time.

The market rewards both fast earnings growth and stable earnings growth. Investors will even buy shares in a non-profitable company that promises to earn a lot in the future (as happened during 1998's explosion in Internet stocks). Declining profits or unexplained losses have a negative effect on share prices. Companies that surprise the market with bad financial or earnings reports are almost always punished with falling share prices.

Company Analysis and Valuation
Company analysis is the means by which investors and their advisors seek to arrive at the best investment decisions. By analysing past performance and the state of today's business, analysts attempt to predict what is likely to happen tomorrow to a company's profits, cash flows and ability to pay dividends.

Company analysis can be a quick check on financial health and profit prospects, or painstaking research using all available facts and figures. Professional analysts build numerical models for predicting profit and other factors several years into the future. This enables current valuation on the shares, and in turn, comparison with current market prices. The analyst provides an opinion on whether a company's shares are under or overvalued, which will ultimately lead to a "buy", "sell" or "hold" recommendation on the company.

At its simplest, company analysis focuses on:

• Price/earnings ratios (or P/Es) - the current share price relative to the company's profit.
• Dividend yield - the rate of return from dividends.
• Net tangible asset backing - the value of assets theoretically attributable to each share in event of the company being liquidated.

Company executives will usually have plans, budgets and forecasts on exactly those things, but there is no accuracy guarantee on a company's view of its own future.

Managed Funds and Passive Funds

There are two main categories of investment funds: managed funds and passive funds.

Managed Funds
Anyone can invest in the stock market directly, or indirectly through a managed fund. The former means buying shares you select through an on-line broker. The latter means buying shares or units in an index fund, investment trust or other form of managed fund which, in turn, buys into various companies on behalf of you and many others. Managed funds have distinct advantages including:

• Greater diversification with the use of relatively less capital. (Diversification means owning a variety of shares and investment types from different industry sectors, so in the event of a major fall in the share price of one company, your entire savings are not threatened.)
• Shares are selected by professionals drawing on rigorous company analysis.

The return on share investing through a fund will be reduced by the fees paid to professional managers and tax on the fund’s capital gains. Indirect investment in shares gives you no involvement in the affairs of the company, as your interests are represented by the fund manager.

Individual investors' objectives will determine their preference for direct or indirect investing in shares. Fund managers, using capital from many investors, are a major feature of any market as they form and manage large "portfolios" of shares (and other forms of investment).

Passive Funds
Passive funds usually track an index and mirror the make-up of that index. They are categorised as "passive" because in following an index, the fund manager does not make decisions on what companies the fund will buy into. The fund is simply re-adjusted to ensure it maintains the correct weightings of the companies that make up the index.

Exchange-Traded Funds (ETFs)
Funds that are listed and traded on the sharemarket. They usually “track” an index by holding a basket of securities with weightings based on the relative index weights of the companies included in that index. Investors buy a share in the ETF, which is essentially a diversified basket of the securities in the index that the fund tracks. As ETFs are normally passively managed, the main costs are brokerage and management fees, which are low compared to managed funds.

Risk vs Return

There are risks involved in any investment - risks that the return will be lower than expected and risks that some or all of the money invested (the capital) will not come back.

Investing is always subject to one fundamental principle - the higher the risk, the higher the return (and vice versa). Some forms of investment, like bank deposits, are widely recognised as low risk but they usually give lower returns. Generally speaking, shares are higher-risk than deposits, debt securities and property. But they also offer the prospect of much higher returns, especially over the longer term.

The risks in share investing are closely linked to all the uncertainties that exist around businesses and the profitability of companies, now and in the future. Some companies - especially those with established businesses and steady profits from year to year - involve far less risk than others (although returns tend to be lower as well).

The risks can be reduced by taking the view of investing for the long term, selecting shares carefully and spreading investment across different types of companies (the process of "diversification"). 

While history shows that share prices will rise over time, there are no guarantees - especially when it comes to individual companies. Unlike debt securities, which promise a payout at the end of a specified period plus interest along the way, returns from shares come from dividends companies pay out of their profits, and capital appreciation of the shares through a rising share price. Neither of these can be guaranteed.

The worst-case scenario is that a company goes bankrupt and the value of your investment evaporates altogether. Happily, that's rare. More often, a company will run into short-term problems that depress the price of its shares for what can seem like an agonisingly long period of time.

In investing, risk is the chance you take that the returns on a particular investment may vary. Because of the increased uncertainty of returns, investors will, all other things being equal, require a higher return if they take on more risk.

For all the risk, however, there are ways to manage your exposure. The best is to diversify by owning a variety of shares and other investment products, such as debt securities. That way, no single company can endanger your savings. It's also important to remember that investors are well compensated for taking the risk with shares. Historically, the long-term return from shares is much higher than for debt securities, which are less risky. Over time, that spread can make a huge difference in the earning power of your savings.

So you'd like to make a fortune in the sharemarket? Who wouldn't? The first thing you need to understand, before you phone a broker or commit a cent to a portfolio, is that it's impossible to realise a return on any investment without facing a certain degree of risk.

No matter what you decide to do with your savings and investments, your money will always face some risk. You could stash your cash under your mattress or in a piggy bank, but then you'd face the risk of losing it all if your house burnt down. You could deposit your money in the bank, but the buying power of your savings would barely keep up with inflation over the years, leaving you with possibly less dollars in real terms than when you started. Investing in shares, debt securities, or mutual funds carries risk of varying degrees.

The second fact you need to face is that in order to receive an increased return from your investment portfolio, you need to accept an increased amount of risk. Keeping your money in a savings account reduces your risk, but it also reduces your potential reward.

While risk in your investment portfolio may be unavoidable, it is manageable. The riddle of controlling risk and return is that you need to maximise the returns and minimise the risk. When you do this, you ensure that you'll make enough return on your investment, with an acceptable amount of risk.

So, what constitutes acceptable risk? It's different for every person. A good rule of thumb followed by many investors is that you shouldn't wake up in the middle of the night worrying about your portfolio. If your investments are causing you too much anxiety, it's time to reconsider how you're investing, and sell those securities that are keeping you awake at night in favour of investments that are a little less painful. When you find your own comfort zone, you'll know your personal risk tolerance - the amount of risk you are willing to tolerate in order to achieve your financial goals.