London Stock Exchange - Why Invest in Shares - Research Proposal Example

London Stock Exchange - Why Invest in Shares? Introduction A stock market is a market structured for public or owned by private for the trading of company stock and derivatives of the company stock at a settled price. It’s the market which facilitates the trading of company stocks (collective shares), other securities and derivatives. Stock market is governed by stock exchange which is a corporation that provides facilities to the traders and brokers to trade company stock and (or) other securities. It also regulates the issue and redemption of securities as well as other financial instruments and capital events like dividend and payment of income. For a while if we go into the history of stock exchange then, it is to be noted that, it was 11th century in France where the courtiers de change were concerned with maintaining the debts of agricultural communities on behalf of banks. These men could be termed as first brokers. Basic roles of stock exchanges can be outlined as below: Facilitating company growth Mobilizing savings for instrument Increasing capital for businesses Creating investment opportunities for small investors. Optimum distribution of wealth etc. This report is all about the importance of stock market and how trading can be done effectively. It discusses about the basic fundamental of stock market and market variation over time and place. In turn, it explains how trading in stock market changes it behavior in time frame. In order to make the study realistic, research has been started with an initial account of amount notional £100,000 to invest and manage and active trading policy is followed. Constraints have been put in shares to be bought in multiples of 100 if the price is less than £2 and in multiples of 50 if the price is greater than £2. Debentures and Government stocks, which have a nominal value of £100 each, may be bought without restriction. Commission is payable on all purchases and sales, at the following rates: Ordinary Shares 1.0% of value (minimum: £10) Government Securities 0.7% of value (minimum: £12.50) Along with that, transfer stamp is payable on all share purchases which is £0.50 for every £100 or fractional part of £100. As it is a study oriented trading, hence no provision is kept for overdraft facilities and no other source of finance. Trading period was till 28th March, 2008; by this time all the holdings were liquidated and after that whatever observation is done, reported here. This paper first discusses what stock market is all about and then the necessity of it. The trading table is presented in section 3 which describes few more basic questions like, how real market is different form theoretical one and what are the factors that market is dependent on etc. Why Stock Market? Why do we need a stock market? Where does the stock come from to begin with, and why do people want to buy and sell it? These are the generic questions for everyone who are not familiar with trading. Let's say that one person wants to start a business, and he decides to open a restaurant. He goes out and buys a building, buys all the kitchen equipment, tables and chairs that he needs, buy his supplies and hire his cooks, servers, etc. He advertises and opens his doors. Let's formulate his business in few lines: He spends $500,000 buying the building and the equipment. In the first year, spends $250,000 on supplies, food and the payroll for his employees. At the end of your first year, he adds up all of the money he has received from customers and finds that his total income is $300,000. Since he has made $300,000 and paid out the $250,000 for expenses, his net profit is: $300,000 (income) - $250,000 (expense) = $50,000 (profit) At the end of the second year, he brings in $325,000 and his expenses remain the same, for a net profit of $75,000. At this point, he decides to sell the business. Now the question is how much is it worthing? One way to look at it is to say that the business is "worth" $500,000. If he closes the restaurant, he can sell the building, the equipment and everything else and get $500,000. This is a simplification, of course the building probably went up in value, and the equipment went down because it is now used. Let's just say that things balance out to $500,000. This is the asset value, or book value, of the business the value of all of the business's assets if you sold them outright today. If he keeps the restaurant going, it will probably make at least $75,000 this year. He knows that from his history with the business. Therefore, he can think of the restaurant as an investment that will pay out something like $75,000 in interest every year. Looking at it that way, someone might be willing to pay $750,000 for the restaurant, as a $75,000 return per year on a $750,000 investment represents a 10-percent rate of return. Someone might even be willing to pay $1,500,000, which represents a 5-percent rate of return or more if he or she thought that the restaurant's income would grow and increase earnings over time at a rate faster than the rate of inflation. The restaurant's owner, therefore, will set the price accordingly. He might price the restaurant at $1,500,000. What if 10 people come and say, "Wow! I would like to buy that restaurant but I don't have $1,500,000." He might want to somehow divide his restaurant into 10 equal pieces and sell each piece for $150,000. In other words, he might sell shares in the restaurant. Then, each person who bought a share would receive one-tenth of the profits at the end of the year, and each person would have one out of 10 votes in any business decisions. Or, he might divide ownership up into 1,500 shares and sell each share for $1,000 to make the price something that more people could afford. Or, he might divide ownership up into 3,000 shares, keep 1,500 for himself, and sell the remaining shares for $500 each. That way, he retains a majority of the shares (and therefore the votes) and remains in control of the restaurant while sharing the profit with other people. In the meantime, he gets to put $750,000 in the bank when he sells the 1,500 shares to other people. Stock, at its core, is really that simple. It represents ownership of a company's assets and profits. A dividend on a share of stock represents that share's portion of the company's profits, generally dispersed yearly. If the restaurant has 10 owners, each owning one share of stock and the restaurant makes $75,000 in profit during the year, and then each owner gets a dividend of $7,500. A large company like IBM has millions of shares of stock outstanding about 1.7 billion in February 2004 (Quicken IBM). In this case, the total profits of the company are divided by 1.7 billion and sent to the shareholders as dividends. One measure of the value of a company, at least as far as investors are concerned, is the product of the number of outstanding shares multiplied by the share price. This value is called the capitalization of the company. It was the example from entrepreneur’s point of view. But if we think from investor’s perspective then, the question still exists. Why should we invest in share (in a high risk market)? Before that, the basic question needs more attention, why should one invest? Simply put, you want to invest in order to create wealth. While investing is relatively painless, its rewards are plentiful. To understand why you need to invest, you need to realise that you lose when you just save and do not invest. That is because the value of the rupee decreases every year due to inflation. For example, if you ran a household within a budget of Rs. 100,000 in 2000, to run the same household today (assuming the same set of expenses) you would probably need Rs125,000 that's Rs25,000 added to your budget because of inflation! Thus you need to generate an additional Rs25,000 and that can be possible only by investing your hard earned money. Options of investing could be in various financial instruments like equities (popularly known as shares), bank fixed deposits, national savings certificates etc as well as gold, real estate et al. Out of these shares give best return on investment. Portfolio Theory and Risk-return: By portfolio theory, rational investors use diversification to optimize their portfolios. It proposes how a risky asset should be priced. Portfolio theory models an asset’s return as random variable in stochastic process and models a portfolio as a weighted combination of assets. The return of it is thus a weighted combination of the assets’ return. According to the model, investors are risk adverse, meaning that given two assets that offer the same expected return, investors will prefer the less risky one. Thus, an investor will go for a higher risk only if there is a large probability of giving higher expected returns. Conversely, an investor who wants higher returns must accept more risk. It can be explained referring the figure 1 below. Low risk means low gain and for higher return investor has to take high risk, Figure 1: Risk and Return profile. The exact trade-off will differ by investor based on individual risk aversion characteristics. The implication is that a rational investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-return profile – i.e., if for that level of risk an alternative portfolio exists which has better expected returns. Figure 2 Example of random variables is temperature and stock prices etc. From figure 2, it is noted that, both the stocks stock A and stock B have same center (average) of 6% but B is more volatile than A. Correlation of two entities measures the common feature between them. An investor can reduce the risk simply by holding instruments which are not perfectly correlated. Diversification will allow for the same portfolio return with reduced risk. Mathematically, Research Description and Finding: With the given initial amount, trading is started keeping into mind the shares of low risk, medium risk and high risk. From theoretical point of view, if all the assets of a portfolio have a correlation of 1, i.e., perfect correlation, the portfolio volatility (standard deviation) will be equal to the weighted sum of the individual asset volatilities. Hence the portfolio variance will be equal to the square of the total weighted sum of the individual asset volatilities. If all the assets have a correlation of 0, i.e., perfectly uncorrelated, the portfolio variance is the sum of the individual asset weights squared times the individual asset variance (and volatility is the square root of this sum). If correlation is less than zero, i.e., the assets are inversely correlated, the portfolio variance and hence volatility will be less than if the correlation is 0. The lowest possible portfolio variance, and hence volatility, occurs when all the assets have a correlation of −1, i.e., perfect inverse correlation. Now, high risk may not give high return. In fact, it may lead to loss too. From the trading table attached this will be clear. Though few of the items were purchased keeping into mind a very high return but at the end of the road, some shares failed to do so. Market can be considered as one random process having mean ‘µ’ and standard deviation ‘σ’. Investor has one expectation and that is considered as mean value but market value will fluctuate around this mean. There are some tools available which can predict the market from the past behaviors. Neural network serves best as this tool. It will take share value of past days and predict the future trend. Past days could be data taken from past three weeks duration or else, past one week depending on share variation. Conclusion The research which has been conducted gives one idea about real market and theoretical one. Though trading was more or less short term but, from this we can infer about long term too. There are some shares which gave very good return. So in short, it depends on the type of company whose share is one going to purchase and current market value. Last but not the least, Investment in shares could be the best if investor executes it in that direction otherwise, it may ruin the business. References: 1) Quicken International Business for Machines. http://findarticles.com/p/articles/mi_hb5053/is_199702/ai_n18370538 2) First step in share market. http://sharekhan.com 3) Getting started in shares. www.asx.com.au/investor/pdf/getting_started_in_shares.pdf 4) Asset Correlation and Credit Portfolio Risk… www.bundesbank.de/download/bankenaufsicht/dkp/200713dkb_b.pdf 5) London Stock Exchange - Why Invest in Shares? www.londonstockexchange.com/.../firsttimeinvestors/investmentfactsheets/whyinvestinshares/whyinvest.htm Read More