Stocks and Styles – Elements 8

This post is part of the Elements series, a Periodic Table of all the Investing Elements that you need to take control of your financial life. You can find the rest of the posts here.

Stocks

What is it?

Today we are talking about the direct ownership of Stocks (shares) as an asset, and where that might be appropriate.

• We’ve already looked at Equities as an asset class here.

A single stock or share represents a small piece of ownership in a publicly listed company, trading on a stock exchange.

• In aggregate, stocks provide exposure to the earnings (profits) of trading companies.

To be precise, equities are the asset class, stocks are companies listed on the exchange and shares are the units of ownership of these listed companies and that you buy and sell.

• Shares in unlisted companies are more properly described as private equity or venture capital.
• This is a separate and more risky asset class which will be covered in a later post.

What kind of element is it?

Stocks are an asset – something you own personally.

Who needs it?

Let’s be clear – everybody needs some exposure to equities as an asset class in order to meet their long-term financial goals, since they are the highest returning asset class of them all.

• How much exposure to equities you are prepared to tolerate will depend on your attitude to risk.

But whether or not to hold stocks directly is a personal decision.

• It’s perfectly possible to get your equity exposure via ETFs, Investment Trusts or even OEICs.

That includes exposure to the sub-styles of equity investment that we’ll talk about below.

What comes before it?

Equities are the riskiest asset class as well as the most rewarding

• So you shouldn’t begin your investing career by buying a few stocks directly.

In practical terms you need a product to put your stocks in – this could be a taxable account from a stockbroker, but it really should be a tax-wrapper like a SIPP or an ISA.

• You should probably steer clear of buying stocks directly within your workplace pension plan, even if it is allowed.

Next there are the prerequisites – you’ll need a financial plan, an annual budget to be sure that you have spare cash to save, and some financial statements to show where you are on your journey.

Next you need to deal with your debts.

• You should have no debts other than a mortgage on the property you live in before you start to invest in stocks.
• And you should build up a cash reserve (six months of expenses is the usual recommendation).

Finally you need to have a plan for where you will live.

• It’s fine – though in the UK, not usually the most profitable long-term option – to rent.
• But if you decide to buy, you need to have a plan for how you will finance this, and you need to be sure that you have spare money on top that can be used to invest in stocks.

Once you’re sure that you’re ready to be in stocks, then you need to decide what type.

• More than any other asset class, equities come in lots of flavours.
• The more flavours you have exposure to, the lower the risk (all things being equal).

The easiest equities to access are those from your home country – in our case the UK.

• We’re lucky that the UK has an outsized stock market in comparison to its economy, and it’s also home to a large number of very international stocks.
• We also have possibly the best junior market in the world – the AIM market – but we’ll consider that as a separate asset sometime in the future.

I’m going to argue that you should only buy equities directly in your home market (the UK).

• You have significant advantages here in terms of trading costs, (lack of) currency exposure, information availability and accessibility within tax wrappers (SIPPs and ISAs).

You could also make an argument for investing directly in major growth areas that are largely centered abroad.

• US tech stocks would be the best example at the moment.
• But even here, it’s usually more practical to access these stocks via spread bets than direct share ownership.

Outside of the UK (ie. Europe, the US, Japan, Asia-Pacific, China, and other Emerging Markets), you should use ETFs and Investment Trusts.

• In general these markets will not move in close step with each other
• The extraordinary financial conditions since the 2008 financial crisis (low interest rates and high levels of central bank intervention) means that correlations have been higher than their historical averages.

What comes after it?

Everything, apart from cash – stocks are the gateway asset.

The reason for this is the riskiness (more accurately, the short-term price volatility) of stocks.

• If they weren’t risky, then the logical thing to do would be to hold 100% equities, since they provide the best long-term returns.
• But of course, if they weren’t risky, it’s unlikely that they would produce the best long-term returns.

What age do you need it from?

For your entire investing career, so ideally from 25 to 75, or even to age 85.

There has recently been a trend towards “life-styling” where proportion of stocks held by a fund is automatically decreased as you approach a “big bang” retirement date.

For me, this thinking is a leftover from the days of annuities.

• Then it was important that your portfolio didn’t lose a lot of value just before it was converted into a monthly income.
• But annuities are poor value now, and retirement will last much longer than it used to.
• In drawdown, it’s safe to stick with equities for the long-run.

What age do you need it until?

You need stocks until you decide to switch from your own retirement portfolio into a monthly annuity payment.

• Given current interest rates and longevity projections, this is unlikely to be before the age of 75.

An alternative scenario would be failing mental faculties which make you no longer feel confident that you can manager your own portfolio.

• If you have no one who can take over for you (via power of attorney), you might want to move into less volatile assets, or even to convert into an annuity.

How much does it cost?

There’s a lot to think about around the costs of holding stocks:

• There are platform costs for buying and holding stocks in an ISA or SIPP.
• There is a spread between the buying and selling prices for a stock – so you have lost a bit of money as soon as you get started.
• And there is stamp duty of 0.5% on a purchase (but not sale) of a UK main market stock.
• AIM stocks are exempt from stamp duty (as are ETFs).

What’s in it?

A stock is a share in the ownership of a company, and hence the right to a share of its future earnings.

• There’s nothing below that at a more fundamental level.

What does a good one look like?

How long is a piece of string?

• A good stock is one that performs “well” – however you define that, in terms of returns and volatility – over the period that you intend to hold it for.
• There’s no way to know this in advance (though there are some rules of thumb to make it more likely).

We’ll look at this again under styles (brands) of stock investing below.

What does a bad one look like?

It’s the opposite of a good one, using the same rules of thumb in reverse.

Any recommended brands?

There are no brands of stocks.

• Stocks own brands, but you shouldn’t necessarily buy the stocks with the best brands.
• Story stocks like Tesla and even successful giants like Amazon and Apple can remain overpriced for years.

So instead, let’s look at the popular styles of investing in stocks as brands.

After geography (covered above), the next most important style is size (market cap, the value of all the shares in issue).

• Small shares have a tendency to outperform over the long-term and so you will probably want a bias towards them.

The other key “equity factors” are value (low PE), momentum (recent share price rises), and low volatility (low beta).

• Each of these tends to outperform, the first two in particular.

There’s also dividend investing, where shares are chosen for their high dividend payout.

• This can be seen as a form of value investing, where the dividends are being bought on the cheap.
• There’s some evidence that plain value investing performs better in the long run than dividend investing, so you might prefer to use that style instead.

Stocks to fit all of these styles can be found using stock screeners, though additional research is advisable before a purchase.

Many investors prefer to specialise in a particular style, but since each of the factors tends to outperform over varying timescales and under different market conditions, we recommend a blended approach.

What are the main risks?

The main “risk” with stocks – it’s really more of a characteristic – is short-term price volatility.

• Since investors like upward volatility, this means drawdowns.

At several points in a long investing career, stock prices will drop by 30% to 50%.

• It’s happened to me three times so far, and I’ve probably got at least one more to look forward to.

The good news is that these falls rarely last very long.

• Most will be done in a year, a few may last for three years.

But you mustn’t sell at the bottom.

• So you need to test your risk tolerance – you can take our questionnaire here.

How do you deal with these risks?

We solve the problem of severe stock drawdowns by diversifying into other asset classes.

But you still need to work out how much stock exposure you can tolerate.

• A simple way to do that (without taking a risk tolerance questionnaire) is to look at your net worth, and figure out how much of it you could cope with losing (temporarily).
• Next, assume that this  “uncomfortable but not intolerable” level is due to a 50% stock pullback.
• Doubling your tolerance then gives you your maximum stock exposure.

Let’s say that you could live with a 20% drop in your wealth.

• To fall 20% because of a 50% fall in stocks, a portfolio would need to hold 40% stocks.
• So 40% is your maximum tolerance for asset allocation to equities.