Chapter 1

Exploring the Basics

IN THIS CHAPTER

Knowing the essentials

Doing your own research

Recognising winners

Exploring investment strategies

Remember Sid? Back in the 1980s and 1990s investing in shares briefly became insanely popular in the UK. Most cynical Brits had grown up believing that shares were a slightly brutish thing, traded by spivs and sleek stockbrokers and only the preserve of the inveterate gambler. The privatisation of the major utilities (Sid was invoked by the Thatcher government to encourage people to invest in the likes of British Gas and British Telecom) changed everything. Suddenly everyone seemed to have amassed a small portfolio of privatised companies as well as shares in building societies such as Halifax who’d chosen to ‘demutualise’ and ‘list’ their shares on the stock market.

Private investors piled into shares in the 1990s as the stock market reached the mania stage at the tail-end of an 18-year upswing (or bull market: see Chapter 15 for more information on bull markets). Some years later adventurous types even took to investing in the companies of ‘tomorrow’ – think Amazon or Google – pumping up an enormous technology-based stock market bubble that eventually burst in spectacular style in the first years of the new millennium (we call this a bear market – see Chapter 15 for more on these). Share prices tumbled worldwide and everyone declared that they were much the wiser.

Now, of course, everyone knows that that was an illusion. Shares picked up in value again in the first decade of the new millennium, especially as investors piled into bank shares tempted by the juicy dividends on offer. And then the GFC – the Global Financial Crisis – came along and the rest is history. Perhaps this time everyone has learned their lesson … or perhaps not! Shares have bounced back in value, which rather suggests that the animal spirits of investing are alive and kicking. And 2020 experienced another exciting roller coaster ride as markets plunged and then soared, and those stocks such as Amazon and Google that were once a bit ‘spivvy’ suddenly turned into ‘must have’.

One might rather cynically conclude after these serial booms and busts that many investors really hadn’t known exactly what they were investing in. If they’d had a rudimentary understanding of what shares really are, perhaps they could have avoided some expensive mistakes. The purpose of this book is not only to tell you about the basics of investing in shares but also to let you in on some solid strategies that can help you profit from the stock market. Before you invest your first fiver, you need to understand the basics of investing in shares, which we discuss in this chapter.

Understanding the Basics

The basics are so basic that few people are doing them. Perhaps the most basic (and therefore most important) thing to grasp is the risk you face whenever you do anything (like putting your hard-earned money in an investment like shares). When you lose track of the basics, you lose track of why you invested to begin with. Find out more about risk (and the different kinds of risk) in Chapter 4.

In an old stand-up routine, the comic was asked ‘How is your wife?’ He responded ‘Compared to what?’ You need to apply the same attitude to stocks. When you’re asked ‘how are your shares?’, you may be able to say that they’re doing well – especially when compared to an acceptable ‘yardstick’ like an index (such as the FTSE 100 or the FTSE All Share). Find out more about indices in Chapter 5.

The bottom line is that the first thing you do when investing in shares is not to send your money straight into a stockbroker’s account or go to a website to click ‘buy shares’. The first thing you do is find out as much as you can about what shares are and how you can use them to boost your wealth.

Getting Prepared before Starting

Gathering information is critical to your plans for investing in shares. You need to gather information on the shares you’re planning to buy twice: before you invest … and after. You obviously should become more informed before you invest your first few quid. But you also need to stay informed about what’s happening to the company whose shares you’re buying, about the industry or sector that company is in and about the economy in general. To find the best information sources, check out Chapter 6.

When you’re ready to invest, you need an account with a stockbroker. How do you know which broker to use and whether to go online or use paper certificates? Chapter 7 provides some answers and resources to help you choose a broker.

Knowing How to Pick Winners

Once you get past the basics, you can get to the ‘meat’ of picking shares. Successful share picking isn’t mysterious, but it does take some time, effort and analysis. This may sound like a lot of work but it’s worth it, because shares are an important part of most investors’ portfolios. Read the following section and be sure to ‘leap frog’ to the relevant chapters.

Recognising the value of shares

Imagine that you like eggs and you’re willing to buy them at the supermarket. In this example, the eggs are like companies, and the prices represent the prices that you would pay for the companies’ shares. The supermarket is the stock market. What if two brands of eggs are similar, but one costs £1 while the other costs £1.50? Which would you choose? Odds are that you would look at both brands, judge their quality and, if they were indeed similar, take the cheaper eggs – though if you’re so minded, you might scrutinise the label for mention of free range.

The eggs at £1.50 are overpriced. The same principle applies to shares. What if you compare two companies that are similar in every respect but have different share prices? All things being equal, the cheaper price has greater value for the investor. But the egg example has another side.

What if the quality of the two brands of eggs is significantly different but their prices are the same? If one brand of eggs is old, of poor quality and priced at £1 and the other brand is fresher, of superior quality and also priced at £1, which would you buy? Of course, you’d take the good brand because they’re better eggs. Perhaps the lesser eggs are an acceptable purchase at 50 pence, but they’re definitely overpriced at £1. The same example works with shares. A badly run company isn’t a good choice if you can buy a better company in the marketplace at the same – or a better – price.

Comparing the value of eggs may seem overly simplistic, but doing so does cut to the heart of investing in shares. Eggs and egg prices can be as varied as companies and share prices. As an investor, you must make it your job to find the best value for your investment cash. (Otherwise you get egg on your face. We bet you saw that one coming.)

Understanding how market capitalisation affects share values

You can determine the value of a company (and thus the value of its shares) in many ways. The most basic way to measure this value is to look at a company’s market value, also known as market capitalisation (or market cap). Market capitalisation is simply the value you get when you multiply all the number of outstanding shares of a particular company by the price of a single share.

Calculating the market cap is easy. It’s the number of shares outstanding multiplied by the current share price. If the company has 1 million shares outstanding and its share price is £10, the market cap is £10 million.

Small cap, mid cap and large cap aren’t references to headgear; they’re references to how large the company is as measured by its market value. Here are the four basic categories of market capitalisation:

• Fledglings: These shares are sometimes known as micro-caps or tiddlers. They’re small and very risky.
• Small caps: These shares may fare better than the fledglings and still have plenty of growth potential. The key word is ‘potential’.
• Mid caps: For many investors, this category offers a good compromise between small caps and blue chips. They offer much of the safety of the big companies while retaining a part of the growth potential of small caps.
• Blue chips: These are the established heavy hitters and are ideal for the cautious investors who want the potential for steady appreciation with greater safety. These companies tend to be represented in something called the FTSE 100 Index of top, ‘blue chip’ companies. We explain more about indices in Chapter 5.

From a safety point of view, the company’s size and market value do matter. All things being equal, large cap companies are considered safer than small cap companies. However, small caps shares have greater potential for growth. Compare these companies to trees: Which tree is stronger – a sturdy oak tree or a newly planted sapling? In a great storm, the oak has a chance of survival, while the young tree has a rough time. But you also have to ask yourself which tree has more opportunity for...