Basic principles for investing on the share market

In short, if you are unsure how to start investing, invest regularly over time in one or two index funds with low fees.

My background

I did my first small investments in some mutual fund and shares 1999 and have been following the financial markets ever since. I have pursued an academic career as a researcher in computational Physics and I obtained a PhD 2014. Simulating complex systems and analysing large amounts of data with statistical methods are my strong sides, which also tend to be useful in the financial field. My investment activities have grown considerably since 1999 and nowadays I am able to fully support myself on my investment activities.

My friends sometimes ask me for advice and my idea here is to write down the basic ideas so that the interested may get a way to start. There are many books and blogs about investing. All I write here is a summary from my perspective and perhaps the perspective of a physicist. I do not have any formal education in economics nor finance. In the end the reader will have to figure out their own investment strategy and take full responsibility for their own investment decisions. I just hope I can tell the reader how to start in a responsible way and how to start learning more.

What are shares, mutual funds, index funds and bonds?

Common ways, instruments, of investing are shares, mutual funds, index funds or bonds. Let us start with some short definitions of these different instruments. More details about these can easily be found in Wikipedia.

• Shares in a company give you part ownership of said company. The market value of a company is decided by the current share price, as traded on the stock markets, and the total number of shares. Commonly, a company gives a part of its yearly profit to the shareholders as dividends one or more times a year. A share also commonly gives voting rights at the shareholder meetings in a company, but this is not so important for small investors. One company may have different series of share (e.g. A, B, C) with different voting rights or dividend rights.
• Bonds are essentially an instrument where you lend money to a state (e.g. US treasury bonds) or a company (junk bonds) and is paid back at a fixed interest rate. The interest may be paid out yearly, monthly or even daily, depending on the bond. The bond will also have a specified duration, such as one year or ten years, after which the whole original loan is paid back. The interest rates are decided by the issuer, the state or company, or in some cases by an inverted auction where the investor who is prepared to lend money for the lowest interest rate will get the bond. Normally, a higher interest rate means higher risk. A company or state that is near default (unable to pay its debts) will have to pay large interest rates in order to borrow money. In recent time Russia defaulted 1998, so it is not unheard of. Otherwise, especially state bonds are considered more safe than shares as defaults are rare. on the other hand, the yearly bond interest rates are usually lower than the value increase you may get from shares in form of dividends and share price increases. In recent years, the bond interest rates have been very small and even negative, which is why I will not talk much about them here.
• Mutual funds are pools of shares or bonds set up and managed by banks or investment firms. The idea is that you pay them to manage this portfolio, that you own a part of, and make all the buy and sell decisions so that you don’t have to. The downside is that they usually take a quite a bit of your money in yearly or monthly fees. Different funds have different specialisations: different sectors, different regions, long or short term bonds, broad or very specialized funds. Mutual funds are generally safer than investing in shares yourself as you get part in a large pool of different shares or bonds, but funds may loose value and they generally cost more in fees.
• Index funds are a kind of mutual fund where the trading is done automatically by computers according to an algorithm. Normally, the fund just try to follow a certain stock index such as the S&P 500 with the largest US companies: If a company’s value is 1 % of all companies included in a certain index, the fund will buy shares in this company for 1 % of its own funds in order to follow the index. Similar indices exist for all stock markets: OMXH for Helsinki, OMXS for Stockholm, and DAX30 for Germany. The advantage with index funds is that the costs are generally low (less than 1 % of the invested value per year, but sometimes even zero fees.) Because of the low fees, index funds commonly give better returns than other mutual funds. The other reason is that human managers of funds are not always as good at picking investments as they want you to believe. If you don’t know how to invest your money, look for an index fund as these commonly have low risk and low fees.

Basic principles

It is basically impossible to say for sure whether certain instrument prices or markets in the future will go up or down or whether a certain company or state will default. However, if you look on historical share prices or stock indices, you will see that they over long time periods tend to go up. However, if you buy a share at a high peak, you might have to wait 20 years before you are able to sell it with profit again. In worst case the company goes bankrupt and you will loos all your invested money, but this is fairly rare. In order to avoid risks like these, what you want is to compose a portfolio of many different instruments (share, bonds or funds). A loss from one instrument is then hopefully compensated by the profits from the other instruments.

The ways to minimize the risks when buying and selling investment instruments are through diversification:

• Build a portfolio with many different instruments. If you only have shares, try to over time get between 10-15 or more different companies. Mutual funds and index funds are already by themselves consisting of many instruments, so 1-3 different funds may be enough, if you have only funds. A combination of share and funds works very well too.
• Do not invest everything at the same time, but spread it out over time. Share prices, and thus fund prices, vary over time. Sometimes the shares are overvalued which is followed by a price correction (a larger drop in price). You want to buy at as low price as possible, but in practice it is impossible to know when the prices are at the bottom before a new upward trend. To avoid buying at the peaks, it is better to buy a few shares at the time with perhaps a month in between until you have as many shares as you want. The same when you invest in a fund.
• Invest in different sectors (IT, forest, industry, banking etc.). If you invest only in a single sector, there is a risk that the whole sector starts to do badly and then your portfolio does badly. Think about what happened to the dotcom companies 2000-2001 (it turned out to be a bubble that crashed with many companies going bankrupt).
• Invest in different markets. If you only buy shares in Finland, it is bad for your portfolio if the Finnish economy starts to underperform. To avoid this risk, also invest in other countries. However, keep in mind that buying shares outside your own country can be expensive in terms of fees and taxes (on e.g. dividends) can become quite complicated. A beginner may ignore this point and in the beginning only invest in their home country, but otherwise there are usually index funds or mutual funds (from your own country) that invest in other markets and this way the problems with investments abroad are avoided.

Other things to keep in mind when investing:

• Look for the lowest fees. For actually buying, keeping and selling shares or funds, you will need a broker, which might be a bank or an online broker. Check what is available in your country and look for the lowest fees. I am myself in Finland using Nordnet (https://www.nordnet.fi/), but there are of course others. Commonly there are fees for buying and selling, but sometimes there is also a yearly fee for just keeping your shares and funds. To give an idea, Nordnet is taking a flat fee of 9 eur for every buy or sell order that goes through, but keeping of the instruments are free. Some banks like to have a percentage fee for buying and selling. Keep in mind that paying say 3 % in fee for selling your share after they have increased in value over many years may be quite more expensive than when you bought them and payed 3 % in fees. Similarly, paying say 0.3 % of your portfolio value in storage fees every year becomes quite costly over time as your portfolio increases in value. Additionally, the principle of compound interest also work negatively on fees: the money you pay in yearly fees will not grow and over time a large part of your potential return has disappeared in fees.
• Beware of taxes. These may vary wildly from country to country. Normally, you pay taxes on dividends and on the profit when you sell an instrument. If your instrument is from your own country, the tax problem should be the easiest for you. However, if you buy share in a company that is based abroad, you might be faces with foreign taxes. As an example: If I as a Finnish residence and shareholder of german shares get german dividends, the German state will take 30 % in tax on the dividends. Then the Finnish state takes an additional 15 % in Finnish tax. However, according to the tax agreement between Germany and Finland, Germany is only allowed to take 15 % in tax, so I have myself to ask back the erratic 15 % tax money from Germany (via a german form). Such issues are not uncommon when buying foreign shares. These are however avoided if you invest in foreign shares via funds based in your own country. To give an general idea of taxes, in Finland, you pay 25.5 % in tax on dividends, and 30 % on profits when you sell shares.
• Do not sell too often. In fact, “buy and forget” is a quite common strategy. Every time you sell, you pay fees and taxes, which means that these are lost money that will not grow profit for you anymore, which they will if you don’t sell. This may make a big different over ten years time. the other reason is that by acting too often you might just be following all other investors in buying and selling-sprees, which means that you typically buy at the peaks and sell after the crashes (opposite to what you want to do).
• Do not invest money you cannot afford to lose if you are a beginner. A good way to learn is to start small and see what happens, but make sure you can afford mistakes and that it is not a a big deal for you if all your invested money would be lost. Over time, as your confidence increase and you under stand the risks, you can increase the investments.

I hope these principles should get you started. If you want to play it safe, invest regularly in one or two index funds with low fees and start small to see how it works. Learn how it works for yourself and be critical to specific investment advises from other people (including banks). Nobody can foresee the future with any real accuracy, but many make money claiming they can, especially in the financial sector. The real challenge is to create a portfolio of investment instruments that steadily grow in value over time with only small fluctuations that you can handle: you want returns with minimized risks. The principles listed in this article should help you construct such a portfolio.