That's an easy one. Historically speaking, investing in shares generates a higher return on average than investing in bonds or putting money into a savings account. However, it does involve a certain amount of risk. Read on and find out more.
What are shares?
A share is a portion of a company. In other words, you are purchasing a certain percentage of ownership of that company. Companies issue shares that represent part of their capital. Some may issue just a few shares, but others may issue millions of them, as in the case of listed companies. A shareholder, therefore, owns part of the company based on the number of shares held.
Why invest in exchange-listed shares?
A listed company uses the money that it raises on the stock exchange to create added value. This in turn can further underpin and boost the economy and the share price, which ultimately benefits shareholders (investors).
You receive something of value in return for your money, namely a share of a company. If that company is doing well and its share price starts going up, the value of your share goes up too. What's more, you may receive some of the profits in the form of a dividend.
Risks associated with share investments
One of the main risks is that you have no guarantee of getting back the money you've invested, since you don't know in advance whether the company will end up making a profit or a loss. If there is a recession or a bankruptcy, for example, shares can lose all or part of their value, causing you to lose all or part of your investment.
The price of a share also depends on many different factors, like:
- Company risks: the company's results, its financial situation, the economic sector in which it operates, how well it is managed, etc.
- External events: political unrest, economic trends, natural disasters and so on.
The interplay of these factors and their unpredictability can cause considerable volatility on the stock market. This can be both positive and negative.
So, the challenge facing share investors is to try and reap any benefits while at the same time keep the risks as low as possible.
How can you reduce risks?
1. Make diversified investments
Put simply, by ensuring adequate diversification you are not dependent on the performance of one company or one sector. If you invest in many different companies, your profit or loss will not be determined by the performance of a single company or sector.
2. Think long term
In historical terms, shares generate a positive return in the long term. This doesn't mean to say that a recession or even a stock market crash will occur from time to time. To date, however, the global economy has always recovered and markets have steamed ahead to new all-time highs.
That's why it's best to invest over a sufficiently long time horizon. It means you can benefit from a potentially high return when things are going well, and you can sit out the crisis when things aren't.
Stock market guru Warren Buffet summed this up nicely in the quote:
Someone is sitting in the shade today because someone planted a tree a long time ago.
If you also reinvest any gains you make on the stock market, you may benefit from exponential growth. That is known as the capitalisation or snowball effect, where your gains might end up generating further gains.
3. Invest at different times
One of the most frequently asked questions by inexperienced investors is, 'When should I invest on the stock market?'
The ideal moment is just after a stock market correction, because you can in effect buy shares at a discount. However, those sitting back waiting for this to happen can sometimes miss out on attractive returns for many years.
The problem is that no-one can predict when the next big fall in prices will occur. A sensible strategy, therefore, is to adopt a staggered approach, where you invest a certain amount each month. That way, you don't miss out on return by continually postponing when to invest. At the same time, you avoid the situation where you've spent a large sum of money in buying shares that have lost a lot of value after a crash.
By diversifying your investments, spreading them over time and holding on to them for the long term, any price fluctuations that arise will have less impact on your final profit.
Investing with funds
It isn't that difficult for individual investors to make long-term investments. But how do you diversify your investments and spread them over time?
Investing in a fund may be the ideal solution. There are definitely many advantages for beginner investors.
A share fund, by definition, enables you to invest in a diversified manner. Depending on the fund, you invest in dozens if not hundreds of shares at the same time. It is also easy to spread your investments over time with an investment fund. You can invest from as little as 25 euros a month by means of an investment plan.
However, you will have to pay certain costs, such as entry charges and management fees.
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