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Webtrader: Understanding shares and market risk

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Shares and market risk


Companies have two choices when they want to raise money to grow their business: to borrow from a bank or issue stocks.

A share represents a proprietary interest that a person holds in a company and shareholders fully participate in the dividends, capital and surplus upon the winding-up of the company The key advantage in issuing shares (or equity) is that the company does not need to pay back the capital amount or make interest payments. Instead, shareholders – the people who buy those shares – can hope to receive dividends and see a capital gain on their investment.

Share trading involve risk. Traders accept these risks every day as they risk a portion of their capital in the hope of receiving a return on their investment. You win some and you lose some. However, the better you understand the risks that affect you as a trader the better you can protect yourself from those risks.

Traders have to confront many forms of risk as they evaluate and manage their trades. For instance a trader who owns stocks in Wal-Mart (WMT:xnys) has to be concerned not only with how well Wal-Mart as a company is performing but also with the general condition of economies around the world. They also have to be concerned with how well the U.S. stock market is performing and whether or not the value of the U.S. dollar is strong or weak, rising or falling.

As you will have to understand all manner of risks if you are to counteract the forces that are going to push your share prices higher and lower. Once you understand the risks facing your trades it is possible to minimize the affect they can have on your profitability.


How a stock exchange works


The New York Stock Exchange (NYSE), the London Stock Exchange (LSE), Tokyo Stock Exchange and the JSE Limited (JSE) are all, simply, markets for stocks.

Stock exchanges have two purposes. Firstly, they are places where traders can buy or sell stocks and, secondly, companies can use them to raise cash to expand their business by selling new stocks to investors.

Stock exchanges provide investors with two advantages:

  • They reduce the risk of investing by providing a transparent pricing mechanism for trades.
  • They police listed companies. Stock exchanges operate in a strict regulatory environment and companies have to comply with stringent listing requirements.

Investors use share indices to track the performance of the underlying stocks and sectors. When we refer to "the market", we're actually referring to an index that is a proxy for all the stocks listed on that exchange.

An index is defined as "a statistical measure of the changes in a portfolio of stocks representing a portion of the overall market". That means that when an index is up, most share prices have increased and vice versa.


What makes a share price move?


In a nutshell, the forces of supply and demand are the key determinants of changes in share prices. In the simplest terms, the share price will go up if more people want to own a share than are prepared to sell it. Over time, a share price will track the underlying trend in the company's earnings: if earnings (and dividends) grow consistently, the share price should follow.

But there are other aspects that affect investor appetite for stocks including the performance of international markets, general economic growth, sector or company-specific news, share buybacks and futures trading.

Overall, share prices tend to go up when the economic news is good as this means companies should see their earnings increase. In addition, good news from a certain sector or company can drive share prices up as investors expect good future earnings.

There are other buyers of stocks apart from investors, including companies (through share buybacks) and futures traders. They also affect the demand/supply equation.


The risks of investing in shares


We've all heard that there's no such thing as a free lunch – and this is as true of investing as anything else. Over time, stocks have outperformed other asset classes – like government bonds, property and bank deposits – but this comes at a cost. That cost is that investing in stocks is riskier than other asset classes. The old adage "high risk, high return" means that an investor who takes on the higher risk of investing in stocks expects a higher return for doing so.

These are some of the risks of investing in stocks:

  • Share prices can – and do – go down as well as up. Investors can reduce their risk by doing their homework and always knowing exactly what they're investing in. That includes evaluating "tips from friends".
  • Some stocks can be illiquid. This means that they can be difficult to trade, often because there is a controlling shareholder who owns a large percentage of the company and is not selling those stocks on the market. This means that a share can be difficult to sell. To avoid this, invest in more liquid stocks.
  • Companies do not have to pay dividends. This is not necessarily a bad sign if the company is keeping that money to invest in its future growth, but is a risk for shareholders who bought that share for the dividend income.
  • If a company goes bankrupt, shareholders may lose the entire value of their investment. Ordinary shareholders only receive what's left over once creditors and preference shareholders have been paid their due.
  • Companies can disappoint the market by reporting lower-than expected earnings. This can mean the share price either falls or lags behind the growth of its peers.
  • Share prices factor in the market's view of management's competence and integrity. Scandals, such as the revelation of fraud or poor corporate governance, can hurt the share price.

But you shouldn't be frightened of investing in stocks. Most listed companies are well-run businesses and their share prices should increase over time.

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