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By Rickey Ward, JB Were
If you are like my folks, a discussion about investing in the share market brings the shutters down quickly. They roll their eyes and are quick to remind me that share markets are risky. The film ‘The Wolf of Wall Street’ hasn’t helped dispel any suspicion. Share markets often make front-page news, but what drives them isn’t well understood by the majority of people. For some, the markets seem shrouded in secrecy, with their every move directed by shadowy figures.
It needn’t be this way. Experience suggests that opinion on share markets is formed as much by a lack of awareness as anything else.
The main risks of investing in share markets
To build wealth over time, it’s generally accepted that an investor has to tolerate a certain degree of risk. If you’re a share market debutant, here are some of the potential pitfalls you should be aware of.
Liquidity is a measure of how easy it is for you to buy or sell shares. Unlike a bond, when investing in shares you’re not guaranteed a return on your original investment. Shares will go up or down for many reasons and your investment will reflect the value of these movements.
There will be times when a lack of liquidity can quickly become a problem. At some stage you may encounter a period when investors, including yourself, wish to sell at the same time. Under the most extreme circumstance this might happen when no one wishes to buy them. While this happens infrequently, if you are unfortunate enough to experience this, your investment may have no value.
Share market crashes
The industry is littered with examples of significant share market falls. It’s always possible these will occur again — and at any time. History suggests you will experience at least one fall in the share market in your investment lifetime.
The impacts of a crash — a large fall in share values in a short space of time — can be severe and are often highlighted by extreme levels of panic. Under such circumstances, significant losses can occur, with investors simply wanting to sell their shares when very few are willing to acquire them.
While recognised signals can pre-empt a crash, they are often not discovered until after the event. Perhaps this is where the saying ‘Harry hindsight’ came from. Every investor needs to be aware that from time to time share markets will correct themselves: call it a crash if you will, but this event alone does not make your investments worthless. You still continue to own those investments, although it may take time, and corrective measures, for them to regain their value.
Despite tighter rules around the way financial information is presented, a company’s earnings can sometimes take investors by surprise. Although companies aim to manage investor expectations, changes in circumstances can lead to profit downgrades and subsequent disappointment.
Markets dislike uncertainty. When downgrades occur, share prices tend to fall, as investors find it harder to predict future profit expectations. After all, future expectations are what investors are buying today.
Profit downgrades can provide great investment opportunities, although many companies will never regain the level of support they once had. Time can be a great healer, but this depends on how well a company’s management explains the reasons for its misfortune.
Companies ‘going bust’
Just because a company is listed on a share market it doesn’t mean it’s protected from bankruptcy. Like ordinary people, companies can face unexpected financial hurdles that affect their ability to repay debt. Sometimes these problems can arise from events outside their control.
Share markets can provide an opportunity for investors to inject more money into a distressed company. However, that company’s survival is not guaranteed. In some instances, investors may decide that investing further money is a fruitless exercise. The value of the company will then only be worth as much as a liquidator will receive from selling it. Under these circumstances, a shareholder ranks below everyone — it might be that following liquidation, you obtain minimal value, if any, for your investment.
How to reduce the chance of these risks impacting your financial well-being
The easiest way to reduce your risk is to seek the services of a qualified financial expert, typically an advisor or fund manager. These people are professionals whose everyday job relies on obtaining and deciphering information. They determine the suitability of an investment and what price you should pay for it.
Not all experts in their field are identical and they will not guarantee that your shares will hold their value. However, they will introduce proven investment techniques, like diversification, to help reduce share market risk.
They say life is nothing without risk. When you buy and sell shares you will face some situations that won’t work out as you expect. Shares will fall, companies will surprise, and every now and then share markets will correct.
If you feel uncomfortable about these risks or are unsure whether you understand them, consider whether investing in shares is right for you.
DIVERSIFICATION: the technique of building a portfolio of different types of investments, so as to spread any potential risk by balancing higher-risk assets with those that have a lower risk.
PROFIT DOWNGRADE: generally issued by an investment analyst, a profit downgrade occurs when the profits for a previously recommended listed company are revised down from a higher forecast.