Shares are popular investments because they offer the highest returns of all the major assets classes over the long-term. Unfortunately, this means shares also come with the highest risk of the major asset classes.

According to a study on share ownership by the Australian Securities Exchange in 2010, around 7.26 million people, or 43% of Australia’s adult population, participated in the Australian share market either directly (via shares or other listed investments) or indirectly (via unlisted managed funds).

Of this total, around 6.6 million people, or 39% of the adult population, held at least some shares directly. The study also showed that around 13% of Australian adults have their own self-managed super fund, with one in two of these funds holding shares listed on the ASX.

Shares are certificates that confer equity ownership rights in some of the leading companies in Australia and the rest of the world. By buying a company’s shares, you are effectively buying a part of the business – and with it a share in the associated risks and rewards that come with ownership.

Let’s say a company in which you own shares goes bankrupt. Those shares will usually become worthless (unless there are some net assets remaining that can be sold and funds partly returned to share owners after creditors are paid). Less drastically, if the company suffers a fall in profits, the value of your shares will also usually fall. A weakening economy also spells trouble for the overall share market.

On the upside, however, the value of a company’s shares usually rises as that company grows and increases its profits over time, and a part of those profits is often returned to shareholders through dividends.

What are the investment returns?

There are two forms of returns from shares: dividends and capital gains. Both also enjoy favourable tax treatment with dividend imputation boosting after-tax dividend returns, while a 50 per cent capital gains discount (for individual shareholders) and a 33% capital gains discount (for superannuation funds) applies to any investment held for more than one year. Extra returns can come from share buybacks and bonus share or “rights” issues that involve either buying from, or offering to shareholders shares on preferential terms.

Over the last 20 years, the annual average compound return from the market was 13%, of which one third came from dividends and two thirds from capital gains.  Annual returns in the past 10 years have been lower at 8.6%, of which around half came from dividends.

In the future, investors should expect annual long-run returns from the Australian share market of around 8%. Clearly some individual company shares will fare much worse and some much better than this, and the market’s year-to-year performance usually varies widely around this long-run expected average return.

How do I buy shares?

With the advent of the internet, it is now quite easy to buy and trade shares directly through online broking websites. Many online brokers have trading commissions from as little as $10 to $30 per trade depending on your level of activity.

Of course, traditional full-service brokers can also be used, which provide additional advice services but usually at a higher cost. According to an ASX survey in 2010, 42% of investors mainly traded through an online broker, 20% used a full-service broker and 25% operated through their financial planner or advisor.

How do I know which shares to buy?

Analysing different aspects of a share market or company can help you decide which shares best suit your investment goals. There are a number of ways you can analyse shares. You may want to look at them based on their industry sector, market capitalisation, growth potential, value or income potential.   

Market capitalisation: This is the total market value of a company’s stocks. So called ‘large cap’ stocks, which tend to be bluechip companies with large capitalisation, are generally less risky than ‘small cap’ stocks. However, they have less growth potential than ‘small cap’ stocks.

Sectors and industries: The global standard is to divide the stock market into 10 sectors, which are then further divided into industry groups. The financials sector and the materials sector account for about two thirds of Australia’s market capitalisation. The remaining sectors are: consumer staples, consumer discretionary, industrials, energy, utilities, health care, information technology and telecommunications. You can minimise risk by spreading your investments over a number of sectors or industries, hedge one sector against another, or up the risk and target a boom area.

Cyclical or defensive: Sectors can be further classified as either cyclical or defensive. Cyclical sectors include materials, energy, financials, consumer discretionary, information technology and industrials and are generally thought to move closely in line with economic activity. Defensive sectors, by contrast, tend to do relatively better (though may still fall in outright terms) during economic and market downturns, as their earnings are not as closely linked to the economic cycle.

Growth and value or income stocks: Growth stocks are typically smaller companies in cyclical sectors and are usually more risky and offer less in the way of dividends, but have the potential for stronger capital gains due to fast growth in earnings. Value or income stocks are typically larger, already well established businesses whose growth has plateaued, but are still able to generate solid earnings and steady income returns via dividends.

Listed investment companies and ETFs: These shares offer access to a diversified pool of stocks picked by professional fund managers. A newer and often cheaper alternative are exchange traded funds (ETFs), which are listed indexed funds that aim to match the performance of various benchmark equity indices that cover the whole Australian market, various industry sectors and even international markets.

Four different types of shares

Fully paid ordinary share: This is by far the most common type of share. It requires upfront payment for the total value of shares purchased and also confers voting rights.

As noted above, through buying a share, you are effectively buying an equity stake in the business, which along with a share in the profits gives you a say in how the business should be run through voting rights at annual general meetings.

For most average investors, however, ownerships stakes are usually too small to have much influence over voting and many investors ignore shareholder meetings and most other opportunities to exercise their voting rights.

Preference share: This is a less common type of share and it is really a quasi-debt instrument. Compared to ordinary shares, they generally offer less upside return, though with lower risk. They confer no voting rights and are less likely to appreciate in value line with company profits but, against this, they usually pay a higher regular fixed dividend payment. They also return capital to investors in the event of company bankruptcy ahead of ordinary shareholders.

Convertible preference share: This is one that offers the right to convert the preference share into an ordinary share at a fixed rate at some agreed future date. This provides investors scope for potentially greater return if the company does well.

Contributing or partly-paid shares: These types of shares cost less upfront but require full payment of the share cost at a future date.

For more on shares, read How to minimise share market risk.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.