How Markets Works

Overview
Welcome to Faida Investment Bank  guide – ‘How the Markets Work’. We have created this guide particularly for investors who are new to the stock market, to provide a foundation of investment knowledge before beginning trading. Experienced investors may also find this useful as a quick refresher.

What are shares?
Shares and the individual Most of us want to save for the future to achieve an important life goal or ambition – buying a new home, sending children to college, or the promise of an early retirement.

Knowing your objectives for the future is the starting point in determining the type of investment you make today and more and more of us are realising the importance of investing directly in shares. Until not so long ago, owning shares was something many people thought was beyond their reach.

Thankfully, times have changed and the tremendous opportunities created by share ownership are now within the grasp of almost everybody. In fact, investing in shares can be one of the most flexible, lucrative and rewarding forms of investment there is.

Indeed, you may already be a share owner without even knowing it – perhaps through a company or personal pension scheme or an endowment mortgage. You may have participated in a privatisation or been a beneficiary of a building society conversion and found yourself joining the ever-increasing numbers of the shareholding public.

This guide is designed to inform you of the benefits of becoming a more active investor. You will not only find information on how the stock market works, but you will find out how the stock market can work for you. The guide gives you a greater understanding of the basics of buying and selling shares and tells you how to match your personal investment preferences to market opportunities. It will help you realise your savings and investment growth potential.

Shares and the economy
The saying is that ‘money makes the world go round’. It certainly makes a big difference to most of our lives – and it’s no different with companies. By and large, it is companies that create wealth in the global economy. But, in order to generate that wealth and take advantage of new opportunities, companies require funding.

Some companies choose to borrow and pay interest on loans. Others give up a degree of ownership in the company and issue shares (or equity). Those companies that choose to offer their shares to the public are known as public companies and these shares are bought and sold on various stock exchanges throughout the world.

Rewards of share ownership
The wealth generated by public companies over the past decade has been staggering. Owning shares gives you a direct stake in this wealth generation process and the opportunity of a healthy return on your investment.
Shareholders generally expect two types of return on their investments; capital gains and dividends.

  1. Capital Gain: Unlike cash investments, shares can produce growth or capital gain in the initial sum invested as the share price increases. More about capital gains
  2. Dividends: Dividends represent the distribution of the company’s profits to shareholders. More about dividend

Risks of share ownership

Of course, share prices are not guaranteed to go upwards and every purchase involves a degree of risk. Whatever your personal appetite, there is much you can do to limit your exposure to risk.
The risks in holding shares can be divided into two categories – market risk and unique risk.

Market risk relates to factors that affect the market as a whole – for example a general rise in interest rates would typically hurt companies across all sectors. There is little you can do to counter this kind of risk.

Unique risk, on the other hand, relates to a specific stock. For example, if you have invested in a pharmaceutical company that is awaiting some important clinical trials, then the risks of holding that particular stock to the exclusion of all others would be large.

Sensible investors and portfolio managers minimise their unique risk by a process known as diversification: simply spreading their portfolio across a range of stocks in a range of sectors.

Putting all your eggs in one basket may be foolish; it is certainly risky – just as a pharmaceutical company dependant on a single, unproven product is a far riskier prospect than a company with a broad range of established products.

Factors moving share prices

The companies listed on, say, the Nairobi Securities Exchange include many recognisable household names. The general share price performance of the companies as a group is tracked by indices such as the NSE Index. Individual share prices vary enormously between companies.
Share price movement is caused by a number of factors both inside and outside the company. These include:

  • The general view on the economy as a whole,
  • The conditions related specifically to the company’s particular industry sector and
  • The performance of the company itself.

Of course, how these factors are viewed is rather subjective. Your decision to buy or sell a company’s share will be based on your own view of its prospects relative to its market peers. You may feel that a particular share is under-priced or overpriced and act accordingly. You may be prompted to act based on something you have read – perhaps a newspaper article or a broker’s research report. Or you may have built up a particular knowledge of the industry or company in question that enables you to form your own opinion.

WHY INVEST IN SHARES?

Shares – the benefits

The key benefits of holding shares are rate of return and flexibility.

Over the long term, shares have outperformed every other investment type including bonds, cash and property.

Shares are exciting! Apart from the very real financial benefits of investing in shares, shares also appeal because individuals like to pit their wits against the market. They derive tremendous satisfaction from picking a winner and letting their friends know all about it.

You have now completed the ‘Why invest in shares’ section of our guide. In the next section you can examine your personal and financial circumstances to determine whether shares are right for you before you take the plunge.

Are shares right for me?

Assess your personal circumstances Before you embark on equity investment, it makes good sense to assess your current personal and financial circumstances and your investment goals.

The first thing to ask yourself is your attitude to risk. You have heard the maxim “no pain, no gain”; this certainly applies to investment. If you want to make gains in the stock market, you may have to take some risks. If you keep all your life savings in safe investments such as a savings account, you will face virtually no investment risk and have some peace of mind, but your return will be lower and inflation could eat away at the value of your deposit.

Your age will also be a factor. Younger investors can perhaps afford to be more aggressive and take higher risks as they have a longer remaining working life to make up for setbacks.

Obviously, whether your have dependants or not will affect your investment decision. You might personally have a strong risk tolerance but this may be tempered by the knowledge that your loved ones’ future may be tied up with your investment decisions.

Whatever your personal circumstances and preferences, however, the unrivalled flexibility of equities and equity-derived products will almost certainly be able to suit your situation.

Your financial position

Your financial circumstances will be a major factor in your approach to investment. You will need to relate your financial position to your overall financial goals. You will also need to place a time horizon on those goals.

For example, you may need to ask yourself whether it might be better to pay off personal debt rather than effectively funding your stock market investments through expensive borrowings. Margin trading (borrowing to trade) is a very specialised area and is not something to be considered by an inexperienced investor. On a long-term basis, it is much better to invest with money you have rather than money you owe. You may decide to liquidate current investments and/or deposits in order to fund your equity investments.

Your financial objectives

Ask yourself what your financial objective is behind your investment and when you hope to realise it. If you are saving for your retirement, for example, you may feel you can afford to be more aggressive because of this longer-term investment horizon.

On the other hand, if there is a possibility you may have a pressing requirement for funds in the short term, it doesn’t make sense to invest in risky, volatile stocks. Indeed, the greater the possibility of short term funding needs, the less appropriate it is to invest in equities, particularly because of the costs involved.

Inform yourself

Your decision to invest will be a lot easier if you inform yourself.

The fundamentals of investing in equities are simple. Once these are grasped, the level of knowledge you can acquire is virtually limitless. There is a huge amount of literature on the subject of investment.

The good news is that you don’t need to be a genius to be a successful investor. After all, it’s a proven fact that professionals don’t necessarily beat the market. But the more you inform yourself, the more confidence you will have and the more peace of mind.

You have now completed the ‘Are shares right for me?’ section of our guide