Introduction to Stock Exchange Investment

This book is about investment in securities quoted on the UK Stock Exchange. This is not as limiting as it appears. As can be seen from Example 1.1, the total market value of all securities listed on the UK Stock Exchange on 30 June 1992 was £2,101 b. There are over 7,300 different securities to choose from and turnover in these securities averaged £1,425 m. for each day of trading in 1991.

This chapter discusses the two most important attributes of stock market securities — risk and return. When considering any security, the investor is always concerned with the return expected on the investment and the risk of the investment, that is, how likely it is that the return expected will be achieved. In a certain world, the return would always be exactly as expected and there would be no risk. The investor would merely have to compare the returns available on different investments and choose those which offered the highest returns.

Chapters 3 and 4 are devoted to a type of security often ignored in investment text books — fixed interest securities.¹ Such a lack of emphasis on this type of investment can partly be explained by the preference for the more glamorous company share sector and partly by the poor performance of fixed interest securities in this century. (For example, £100 spent on 21/2% Consols at the beginning of 1919 would have been quoted at £2511/16% on the first day of 1992 and worth in real terms only 11/2% of its 1919 value.)

In Chapter 3, we looked at how gilts differ from one another, through their coupons and maturities, and examined how measures of return on gilts, notably the interest yield and the redemption yield, can be calculated. In this chapter, we concentrate on how to choose between fixed interest securities, in particular gilts, from the point of view of investment.

We examine in this chapter the valuation of ordinary shares. Ordinary shares, or equities as they are also known, are by far the most important type of security issued by UK and Irish companies. On 31 March 1992, there were 797 loan capital securities and 1,068 preference shares of UK companies quoted on the Stock Exchange (including the Unlisted Securities Market) compared to 2,313 ordinary shares,¹ and yet the ordinary shares represented 95% of the market value of all these UK corporate quoted securities. The ordinary shares were worth £543b., over four times more than the market value of UK gilt-edged stock of £133b. Despite this, ordinary shares represented 26% of the total market value of the UK Stock Exchange on that date. This percentage figure is misleading, since 58% of the Stock Exchange’s total market value consisted of the securities of overseas companies, that is, shares which are quoted primarily on overseas stock exchanges. If these shares are excluded, UK and Irish company ordinary shares represented 72% of the market value of the Stock Exchange with gilts contributing a further 18%. The bulk of the remainder is eurobonds, referred to in Chapter 4.

In this chapter, we introduce options. The ability to buy and sell options on a wide variety of instruments has been the most interesting development for investors of the past decade. Options offer the investor the ability to create a wide variety of risk and return alternatives from the same underlying security. Options allow investors to take a view not only on prices in a market but on the volatility or risk of that market. Options also form the basis of all the securities we have already come across. Options are the building blocks of investment. An understanding of futures and options, or ‘derivatives’ as we saw in Chapter 6, is of importance to both private and institutional investors.

In Chapter 2 we discussed how to measure the most important characteristics of a security, its return and its risk. We decided that, for each security, investors would compare the expected return from a range of probable outcomes with the risk of the security, as measured by the standard deviation of the probability distribution of returns.¹ So, investors would only need to consider expected returns and standard deviations when choosing securities for their investment portfolios. They would, since they were assumed risk averse, choose those securities which offered the most return for a given level of risk or the least risk for a given level of return.

We saw, towards the end of Chapter 8, that finding an optimal portfolio using portfolio theory requires a computer program and a rather large variance-covariance matrix. This has hindered general acceptance of portfolio theory, despite its usefulness. We also saw, in the section called ‘Size of Optimal Portfolio’, that however much we diversify and however many securities are included in the portfolio, risk cannot be reduced, using a naïve diversification policy, to less than a certain amount. This is because as we hold more and more securities, we end up holding the whole stock market, and thus bearing the risk of that stock market, which cannot be diversified away. This concept of undiversifiable market risk, as it is known, is fundamental to the development of the more rigorous capital asset pricing model (or CAPM), which is described in this chapter. The CAPM shows that the risk of any security can be divided into two parts — the element which reflects that undiversifiable market risk and an element which is specific to the share and which can be diversified away when the share is held as part of a large portfolio.

So far in this book, we have mainly restricted ourselves to securities issued in sterling by a UK company or the UK government. This emphasis is misleading since, as we saw in Chapter 1, over half the market value of securities quoted on the London Stock Exchange is made up of overseas securities,¹ traded in London but not necessarily in pounds and pence. For example, an IBM eurobond may be denominated and quoted in dollars and Deutsche Bank shares will be quoted in German deutschemarks. However, international investment does not have to be made via securities listed on the Stock Exchange in London. Foreign securities such as US Treasury bonds or Japanese equities which are quoted in markets other than the UK stock market can be bought via brokers based in London or overseas.²

This chapter stands apart from the others in this book, in the sense that it is not directly concerned with how to value particular securities or with how to value an investment portfolio. It is concerned instead with a group of principal actors on the Stock Exchange investment stage, that is, with those financial institutions which are the major investors in Stock Exchange securities. No book on investment can ignore these institutions — pension funds, insurance companies, investment trusts and unit trusts — firstly, because they are the intermediaries through which the vast majority of people knowingly or unknowingly invest in stock market securities and, secondly, because their presence is now so major that every facet of investment, from performance measurement to the role of market makers and analysts, is affected by their existence.

In the first twelve chapters of this book we looked at different types of Stock Exchange securities, how to value them and how to compare them through the medium of expected holding period return and risk. We also considered the advantages of portfolio investment, both domestic and international, and the different requirements of the institutional (as opposed to the individual) investor. In this final chapter, we examine the investor’s overall strategy, from the factors he should take into consideration when quantifying his objectives to the measurement of his actual investment performance.