Shares – Related Matters
Stock Market Float
Sometimes companies new to the stock market will have a ‘float’ – there will be an initial public offering of shares. This might be when a private company goes public in order to raise money for expansion. It might also happen when a formerly government-owned company is listed on the stock market. Readers might remember when Facebook first went public and floated on the stock market in 2012.
These tend to be risky investments as the value of the as-yet untraded shares is still uncertain. When we get to the part on how to invest in shares, I will not recommend specifically buying newly-floated shares.
As mentioned earlier, there are both private and public companies. So far we have been talking about buying shares in publicly-listed companies.
A company that is not listed on the stock exchange is called a private company, and it is possible to invest in these, too. They usually raise money from a smaller number of investors, mostly investment firms or very rich people, and are not subject to all the regulations that public companies are subject to.
Private equity is probably suitable for more sophisticated investors than my target audience. I’ve listed it here so that you know what it is, but you should get plenty of experience in plain old shares, plus put together enough money to properly diversify, before you start looking at this option. Most people never need bother themselves with private equity.
This is when a new business seeks initial, private investments to get started, alongside advice on how to move forward. This is way too sophisticated for my readers and is listed here only for your information in case you hear the term come up.
Some people invest in the stock market for the short-term, rather than long-term, and this is usually called day trading. This is where you speculate about very short-term fluctuations in the market rather than hold stocks for a long time. You’ll see ads around for guys who promise that their trading system is awesome and if you follow it, you’ll be able to make heaps of money working from home as you learn how to mess around with options, futures, go long and short, and all that sort of thing.
These days, very wealthy firms with expensive supercomputers and math wizzes paid dizzying amounts of money are already using incomprehensibly complex and lightning-fast algorithms to detect any misevaluation or change in the market, and profit from it. Sometimes they even rent office space as close as possible to the stock market in order to enjoy a tiny fraction of a second reaction time advantage compared to their competitors.
How is an average Joe like you going to make a killing in such an environment? Simple: you won’t. There’s plenty of research that shows 95% of individual day traders end up making a loss,[i] and the longer they have to practice, the worse they get.[ii] I guess that must be a statistical weeding out of beginner’s luck.
It’s a scam. Do not attempt day-trading or anything like it unless you are already a financial whiz – and if you were one of those, you would not be reading this book.
A hedge fund invests in various esoteric, alternative and very complex areas, using sophisticated trading algorithms and super clever people. The idea is that they can continue to make oversize returns even when the overall market is doing poorly, hence ‘hedging’ your returns.
When the Great Recession hit in 2008, 7% of hedge funds had closed down by the end of the year – not a great result.[iii] Apparently many of them were largely betting on future growth in the stock market, which isn’t that esoteric at all, and certainly will not hedge your bets if you’re also investing in the plain old stock market itself.
Hedge funds might have their place for sophisticated investors, but for ordinary investors like you and me they are best avoided unless/until we acquire much more experience, expertise and capital. Again, they are listed here so that you know what the term means if it comes up.
‘Gearing’ means that you borrow money to invest in (usually) shares. These are sometimes also called ‘leveraged’ investments or margin loans. You can invest in a geared managed fund or you can directly borrow to invest. It is also possible to use gearing to invest in real estate, which we’ll address in that section.
Remember how we learned back in Step 1 that we should avoid getting into new debt? Good. Well, is gearing a good debt or a bad debt?
For some people, gearing can increase their returns. For example, say you borrow $10,000 at 6%, buy shares, and get a return on the market of 10%. The $10,000 turns into $11,000. After paying back the principal ($10,000) plus $600 interest, you’ve still got that extra 4% return – $400 – in your pocket. Free money! Yay!
But what if the market doesn’t return 10%? What if, in fact, it falls? In the case that your proportion of capital against the loan falls too low, the lender, or broker, will demand that you immediately pay extra money or security in order to bring the investment back up to the broker’s required amount. This is called a ‘margin call’.
If you are a very rich, highly sophisticated investor, understand that last paragraph perfectly, could write twenty more paragraphs explaining how it works in much more detail, and you have cash reserved in case of a margin call, it might be worth your while.
If, on the other hand, you are the expected reader of this book, geared investments are almost certainly not for you. If you get a margin call and can’t pay up, the lender will make you sell enough of the shares to bring the value of your investment back to the minimum required. This is really bad news because it will happen when the share price has fallen, so you will be forced to realize a significant loss.
A lot of people made huge losses on geared investments during the Great Recession. For most of us, shares are risky enough without borrowing extra money to invest in the market.
There are those who’ll tell you that you’ll never get anywhere financially without gearing. ‘You need to turbocharge your investments!’
This is not true. Plenty of investors only invest their own money, wisely and diligently, and end up with enough for a high level of financial freedom without taking inordinate risks. Then there are those who take out margin loans to get a bit more growth and finally suffer big losses that force them to retire later or less comfortably than they had expected.
You do NOT have to gear in order to get ahead.
Gearing can turbocharge both your returns and your losses. Be aware that advisors who push gearing are advocating a high-risk strategy – is that what you told them you wanted? More about avoiding dodgy advisors in Step 9.
If I still have not convinced you to avoid gearing altogether, at least limit yourself to borrowing just a little bit to invest in shares. If more than a third of your money in the market is borrowed, that is hugely risky and it could all come crashing down at any moment. For me, borrowing nothing to invest is plenty risky enough.
Note: we also refer to companies that have borrowed heavily as highly ‘geared’ or ‘leveraged’. That is a separate issue.
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