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STOCKS, BONDS AND OPTIONS

A beginner's guide to what's in store for 2018

Investing remains a core device that anyone can use to build wealth. Your approach doesn’t have to be overly complicated, but you do need to develop an understanding of what’s involved.

Before you get started, get comfortable with some of the basics. Below is a very simplified rundown on stocks, bonds and options.

Don’t get too wedded to the headings. For example, investors certainly use stocks to speculate and to earn income. The important thing is to get a sense of their principle uses and what they have to offer.

Stocks: Capital Growth

Quite simply, a stock (also aptly known as a “share” and “equity”) is a part-ownership of a company.

So, when you buy shares in Microsoft, BP or Next you are buying a stake in the company and the chance to benefit from its future growth. It’s unlikely you’ll ever own enough to influence the Board of Directors, but if the company performs well your investment should see above-inflation growth as a minimum. You may also be entitled to additional income if the company pays a regular dividend.

The tricky bit comes from knowing what and when to buy. There’s no easy answer to this and is the reason why a multi-trillion-dollar investment industry flourishes. There are also no guarantees that you’ll get your money back as investors in now-defunct Marconi, Enron, WorldCom and Game Group will testify. But whether you are a market professional or just starting out, it’s worth having a process that allows you to select potentially profitable investments.

Your approach could be based on fundamental analysis, where you analyse the company’s financial statements, market position and economic prospects to evaluate its prospects. Dovetailing that, you may decide on whether a target investment is good value, looking at key industry metrics, such as the price-to-earnings and price-to-book ratios. It’s not an exact science but such an approach gives investors yardsticks to gauge whether a share is cheap or expensive relative to others. Alternatively, you could also go down the technical analysis route, where you analyse charts to interpret past share price action to extrapolate future stock performance.

If stocks are the path you want to take, you should look to build a portfolio balanced across names with different characteristics, spreading your risk. This could involve combining domestic and international names, shares from fast- and slow-growing sectors, or mixing large and small market capitalisation companies.

Bonds: Income

When you buy a share you become an owner, but when you buy a bond (also known as a fixed income instrument) you’re effectively becoming a lender.

It might sound odd that you could be lending money to the US government, Debenhams or the Royal Bank of Scotland. But it’s normal for governments and corporations to sell bonds in the market to raise money to meet their obligations.

Whoever issues the bond is obliged to periodically pay a fixed interest rate coupon until it matures.  So, as with any loan, there’s cash earned on the capital lent, and is why bonds are valued for their stability and predictable stream of income.

Although you are giving up the chance of capital gains, you are in the main locking in income and reducing volatility – particularly important for pension needs. By providing more reliable returns, bonds help an investor’s portfolio balance out the uncertainty of stock market investing.

Not all bonds are created equally, however. A higher interest rate isn’t always the best deal, as bond issuers with poor reputations and higher risk tend to offer better rates. You’ve got to wonder whether that small Mongolian property company is good for both its attractive 12% coupon and will return your capital at maturity.

Those with the highest default risk are commonly called ‘high-yield’ or ‘junk’ bonds, as opposed to those with little chance of default referred to as ‘investment grade’ bonds.

Bonds aren’t always great value for investors either. Suppose you buy a bond with a £100 face value and hold it for 10 years. At the end of the term you will get back your money and will have benefited from the regular coupons. But your £100 won’t look nearly as attractive if the purchasing power has been ravaged by inflation over the period and is now the equivalent of £50.

Options: Speculation and Trading

Investment guru Warren Buffett once described derivatives as “financial weapons of mass destruction.” He wasn’t specifically talking about options, but the comment does reflect the higher risk associated with the space.

While stocks give investors a small piece of company ownership, in their most simple form options are contracts that give you the right, but not obligation, to buy the stock (“call” options) or sell (“put” options) at a specific price by a specific date.

They can be used to reduce risk but are popular amongst speculators as they offer the chance to generate outsized returns through taking directional bets with a lower outlay.  Rather than stump up the full amount to buy 100 Netflix shares, you can simply stake a premium payment for the right to buy later.

Option strategies offer an array of risk-reward outcomes, couched in a whole new lexicon. You could be covered call writing or naked put writing, or using collars and bull and bear spreads, amongst others. The possibilities are vast.

Although most beginners will start with strategies that simply risk the premium paid, it’s important to know that losses can stack up if you are on the wrong side of certain trades. In the extreme, naked call writing (where you sell call options without owning the underlying security) could expose you to unlimited losses. Options are complex and not for everyone. Do your homework upfront.

Looking at 2018

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” While this additional Buffett insight may be slightly unkind, it’s true to say that predicting the future is risky business.

The big question for investors is whether the exceptional stock market performance we’ve seen since 2009, and notably in 2017, can continue for much longer.  

A host of challenges lie in wait:  geopolitical tensions in the Middle East, the corporate debt picture in China, rising interest rates in the US, Brexit talk uncertainty, the European Central Bank’s ending of quantitative easing, slowing global growth, rising inflation, and so on.

Investors still remember the financial beating they took during the global financial crisis. And given the exceptional market performance last year, they may choose to adjust their expectations for this one.

The outlook for the bond market looks even less inspiring than the stock market. Central banks are set to raise interest rates more aggressively globally to counter the threat of inflation, with both elements posing huge negatives for the asset class.

Regardless of the backdrop, there will always be market opportunities to consider:

  • US Infrastructure Spending: If President Trump’s agenda does manage to get pushed through, there could be opportunities in the materials and industrials sectors, benefiting the likes of Vulcan Materials (VMC), Caterpillar (CAT) and Cummins (CMI).

  • Cryptocurrency and Blockchain: Think about building exposure to one of today’s most significant trends through names such as Nvidia (NVDA) and AMD (AMD).

  • Cannabis Deregulation in the US:  While not to everyone’s taste, there are several small cap names exposed to the theme, including AusCann Group (ACNNF) and Canopy Growth (WEED).

  • High Dividend Yield: In this low return environment and in times of market volatility, stable companies with good dividend yields, such as Royal Dutch Shell (RDSA), Centrica (CNA) and HSBC (HSBA), tend to offer relative protection when compared to high growth names.

For those new to investing, it’s important to adopt the adage of not putting all your eggs in one basket. The more you’re able to spread your risk, whether that’s across different types of stocks or across entirely different asset classes, the more protected you will be from inevitable market lurches.

Markets don’t go up in straight lines and stocks certainly won’t continue to push higher forever without a period of re-balancing. Keep improving your knowledge to help you navigate uncertainty.