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The stock market allows companies to raise money, for instance to finance expansion plans. They raise these capital sums by selling shares in the business to public and institutional investors. The shareholders are the company's owners and are entitled to a share in any profits. Profits are distributed by way of a dividend payment. Sometimes profits are retained within the business to increase future profit, assuming that shareholders are happy to receive less income for the promise of higher potential growth.

Companies listed on the stock market are PLCs - Public Limited Companies. This means that ordinary shareholders have limited liability: they can lose no more than the cash they have invested.

London Stock Exchange

The London Stock Exchange (LSE) is one of the oldest and largest exchanges in the world. It serves companies coming to the market - new issues or initial public offerings (IPO) - and investors eager to own a part of a quoted company. Shares are first issued in the primary market, and then traded in the secondary market. Around 99% of the Exchange's business takes place in this market of "second hand" stock.

To join the main market, companies must meet certain criteria specified by the LSE: for instance, a minimum market capitalisation of £700,000, with at least 25% of the company to be floated, and a minimum three year trading record.

For those who do not meet these requirements, AIM (Alternative Investment Market) has less stringent entry rules. There are a number of indices on the London exchange.

Dealing, Market Makers and the Order Book

Once there was "open outcry" on the floor of the LSE, as the Jobbers in their old fashioned hats traded stocks on behalf of brokers by shouting apparently incoherently at each other, the brokers themselves dealing on behalf of clients. Market Makers sitting in front of screens replaced Jobbers in 1986.

Through Bid and Offer prices (sell and buy), Market Makers must offer two way quotes up to Normal Market Size (NMS) in all of the stocks in which they are licensed to deal. Reduced Size Market Makers must only offer prices up to a reduced size. However, this applies to all stocks in which they are licensed and they are not allowed to quote at in a greater size. The difference between the bid and offer, the margin, can be considered as their profit. When dealing online, prices are offered by market making Retail Service Providers (RSPs) who operate under looser constraints.

There are four market systems on the LSE. When investors place an order with their brokers, it will be dealt via one of these routes.

Stock Exchange Automated Quotation System (SEAQ)

SEAQ is a quote driven, competing Market Maker system. The liquidity of stock varies, but the companies must attract at least two Market Makers.

Stock Exchange Electronic Trading Service (SETS)

In 1997 the SETS Order Book was launched. This order driven system operates in the most liquid stocks (FTSE 100 through to part of the FTSE 250) and works by matching orders of those wishing to buy and those wishing to sell. See the London Stock Exchange's website for more information.

Stock Exchange Automated Trading System (SEATS Plus)

AIM stocks and all other listed companies that are likely to be relatively illiquid are traded here. The system operates as basic order matching along with some Market Maker Support.

SEAQ International

Competing Market Makers deal in liquid international stocks that are traded in London.

When dealing, an investor is faced with a bid price and an offer price. The bid price is that at which the investor may sell stock and the offer the price he or she can buy. Ordinarily, the price at which an investor deals will be at 'best', that is, the best price available in the market at the time of the deal. Under normal conditions, brokers will provide the 'best' price.

Settlement

In the UK, the de-materialised (that is, electronic rather than paper-based) settlement system is known as CREST. CREST facilitates electronic settlement using a 'book entry' system by transferring stock and communicating with the appropriate Company Registrar. It will also create a payment receipt on the Cash Memorandum Account of the appropriate institution. The registrar's role is to maintain accurate records of all shareholders.

Standard equity settlement in the UK is three working days (T+3). Private investors' stock is often held in a nominee account rather than in certificated form. This means that legal ownership of the stock is passed to the Nominee Company, for administration purposes, although the investor remains the underlying beneficial owner. This arrangement makes settlement quicker and more efficient. It also dispenses with the need for signed transfer forms when a sale occurs. Dividends are collected centrally and paid directly into investors' dealing accounts.

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The stock market is the exciting end of personal investment. Before you begin to build a stock portfolio, however, you should consider more fundamental financial planning. Investors should be satisfied that they have made appropriate provision for debts, savings, mortgage, pension and life assurance.

Debts

Overdrafts, long-term credit card liabilities and loans are expensive. It does not make sense to run these sort of debts and at the same time investing in stocks; your stock market return will merely subsidise the banks and credit card companies.

Savings

Is there sufficient contingency cash in the bank or building society? Stock market decisions should be made on investment grounds and not to achieve short-term liquidity where market conditions may not be favourable.

Mortgage

Buying a house is a major investment as well as a roof over your head.

Pension

Provision for retirement is important and generally should not be delayed. There are also advantageous tax allowances.

Life Assurance

You need to be sure you have made adequate provision for your individual circumstances.

Starting Out

For many, their first experience of share ownership is through building society conversions, privatisations, shares in the company for which they work or maybe in the football team they support (although few of these have proved profitable).

This is an excellent starting point because the chances are you will already have some good knowledge about the companies you are investing in. The starting maxim is: invest in what you know.

The most famous investor of them all, Warren Buffett will not invest in a company unless he completely understands what they do. Investors should think about the sectors where they have some specialist knowledge. You may work in say retailing, engineering or telecommunications. Thinking about the current successes (or failures) of the business sector, you are as likely to be as knowledgeable about its prospect as many analysts. This means it may be possible to invest in trends ahead of the market. Once you are familiar with one sector, you can move on to examine another.

Investment Growth

The stock market is attractive to investors because of the consistent long-term returns. Over the longer term, the stock market has out-performed gold, gilts and even house prices. Consider also the benefits of compounding. A little invested earlier will produce longer term returns that will be difficult to match from a later starting point even if larger sums of cash are involved.

Compounding means that modest investment made early in the stockmarket can become a sizeable investment over the long term. We all remember being taught compound interest at school and the principle is the same when examining the stock market. £1000 invested in year one may grow at say five per cent meaning that at the beginning of year two the investment has become worth £1050, profiting by £50. If investment growth remains at five per cent at the beginning of year three the assets are worth £1102.50, the next year £1157.63, £1215.50 the next and £1276.28 after just five years, profiting by £60 on the previous year and £276 on the original investment.

Now consider that the UK stock market does not grow at five per cent. During the twenty years from 1980 to 2000, the market has produced annual returns, in real terms, of about 12% (and this figure ignores dividend income.)

That £1000 would have grown to £1762 over five years. Over twenty years it would have become £9646. A useful guide to the power of compounding is to look at the FTSE 100, which currently stands at over 5,000 (May 2002.) This index was launched in 1984 and based at 1000. While this comparison is not entirely fair - because the index is composed of the most successful companies, brutally expelling those which under perform - it is worth reflecting on the performance of a FTSE 100 tracker during that time.

Compounding really demonstrates its worth, not when examining the performance of a lump sum, but when saving and investing on a regular basis. If we assume an annual growth rate of 12% and you manage to save £200 per month for ten years, you will have amassed assets worth more than £47,000. This is impressive enough. Now suppose you stop saving but leave the assets to grow. Twenty years later, those modest investments would be worth £455,000.

Starting Early

The lesson of compounding is to start early. A little earlier on is worth a great deal later. In the above example, ten years saving £200 per month turned into £455,000 when compounding was allowed to take effect over a further twenty. Say you needed those assets for retirement; to catch up during those final ten years would require a monthly investment of closer to £2000 (although this is still better than putting the money under the mattress where you would need to save some £3800 every month).

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Your Objectives

You should establish your objectives from the outset. Are you investing for a specific requirement, perhaps university costs, buying a house or early retirement? Is it simply to build up a nest egg or maybe to speculate on the markets? Investors should have particular objectives, attitude to risk and time horizons in mind when they are selecting their investments.

Young and Old

You need to decide the balance of income and growth you require. Generally, younger investors invest for growth with limited income and move into lower risk income stocks in retirement. A younger person who has money to invest will probably have little need for income (which will be taxed) and able to take higher risks because there is more time to rectify mistakes. Conversely, an older investor may convert growth into a source of income.

Timescales

The length of time you are able to invest will impact on what investments you choose. If you are able to invest for the longer term, you may be able to ride out periods of short-term volatility. However, there is always a risk that markets may be volatile when you want to access your money. When investing for the longer term, you could also consider regular investing as this way you can take advantage of pound/cost averaging; this is the averaging affect of buying more shares when the price is lower and fewer when the price is higher – over time, this can help even out the ups and downs of the market.

Risk

The potential returns from stock market investment are impressive but they are not risk-free. It's an old adage that historic returns are no indication of future performance and that prices may go down as well as up. There are few guarantees in the market and it is fair to say that the higher the risk, the higher the potential returns.
It is important that you form an attitude to risk. This will differ from investor to investor. Some will revel in high risk, speculative stocks while others will prefer a more sedate selection of securities. Investing should not keep you awake at night, and if your investments are a constant worry, they are probably too high risk. Take the risk quiz to find out where you sit on the risk spectrum.

Diversifiy

Two basic risks associated with holding shares are stock specific risks and sector specific risks. Creating a diversified portfolio can reduce your exposure. If you put all of your money into the shares of just one company you expose yourself to the risk of that company falling from favour. By investing in two companies, the stock specific risk is halved; with four companies it is a quarter of what it was. It's sensible to have no more than 15% of your portfolio in one individual stock. Reducing stock specific risk is not enough. The diversified portfolio reduces sector specific risks by holding shares in a broad selection of sectors. A diversified portfolio might include oils, pharmaceuticals, brewers, telecoms, technology and utility stocks. Utilities and food companies are traditionally considered to be defensive stocks and may give you some buffer against turbulent markets. Diversification across investment instruments is also sensible depending on particular risk attitudes and objectives. It is important to select instruments suitable for the individual objectives, attitude to risks and time scales that you have in mind. Use the risk ladder to see the different risk characteristics associated with different types of investment.

Large and Small Companies

Larger companies, or blue chips, are generally considered to be lower risk than smaller companies. Not only are they less likely to go out of business but there will also be more information and research available, making decisions more certain. The converse is that smaller companies have a greater capacity to grow and have potentially superior returns if stock selection proves successful.

Look Abroad

Another way of protecting yourself against turbulence is to invest in overseas markets where political and currency risks differ from your home market. Please bear in mind that fluctuations in exchange rates may affect the sterling value and any returns from investments.

Overseas markets also allow exposure to sectors unavailable at home. For instance, there are no car manufacturers quoted on the FTSE. If you wanted to gain some exposure here you would need to look to Germany or the US.

Collective investments offer a convenient way of creating exposure to overseas markets and specialist sectors when direct investment is difficult. They are also a sensible way to achieve diversification in relatively small lists as they act as well-structured portfolios in their construction.

Investors should always consider building up a core portfolio of diversified blue chips and collective funds before moving on to more speculative shares.

Model Portfolios

One advantage of selecting and managing your own investments is that you can tailor to fit your personal aims, objectives and attitude to risk. Take a look at these model portfolios to help you get started.

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All investors, whether they know it or not, fall into one or more categories of investment strategist. It is important to be clear, when establishing objectives and attitude to risk, what sort of strategy you intend to pursue.

Value investing

Value investors seek out hidden 'value' that the market has missed. They invest in what they consider to be undervalued stock and wait for other investors to reach the same conclusion.

Value investing is only possible in inefficient markets. Where a market is efficient - where there is near perfect information - stock will not be undervalued but will trade at a level the market considers fair value. In the larger blue chip markets like the FTSE 100, many investors, analysts and researchers operate, making the market largely efficient (although the market is affected by fashions and fads, so ignored sectors and stocks may offer value).

Value is more often found among the smaller companies, because poor liquidity makes it difficult for the institutions to operate and so there is no need for analysts to track these companies. Smaller companies are generally the preserve of the private investor but they represent higher risk.

Growth investing

Value is not the most important factor for growth investors. It is a bonus if value is achieved, but growth investors select quality stocks that they believe will achieve superior returns over the longer term. A growth investor is, therefore, unperturbed when purchasing stock towards the top of its range. The risks involved in growth investing are lower than that of value investing, but the potential may be less spectacular.

Contrarian investing

Some of the greatest investors of all time (Buffett, Templeton) can be considered contrarian. The contrarian approach is to examine stocks and companies, forming a view on their potential, irrespective of what the rest of the market is doing. It does not mean always doing the opposite of what the market does (after all the market is sometimes right.)

However, contrarians are unconcerned by the short or even longer-term herd like movements in the markets. Successful contrarian investors have become very wealthy. However, it is an approach requiring nerves of steel and a great deal of independent analytical work.

Passive v active strategies

The extent to which you want to take an active involvement in your investment strategy will also influence your approach. Value and contrarian investing, to varying degrees, require considerable involvement. Growth investing, while it can be very involved, may be relatively passive. This depends on the mix of securities. Blue chip and collectives will require less work than FTSE 250 and smaller companies.

Collectives	Diversified base	Active investment in
Blue chip growth	Some growth/ value	growth and value stocks
Gilts	stock selection	Overseas stock

Low maintenance

Medium maintenance

High maintenance

Ethical investing

You might also want to consider the concept of ethics in your investment strategy. On a basic level, this might mean avoiding tobacco and arms companies. On a deeper level, you might wish to investigate further a company's record on the environment, its respect for its workers or involvement in countries with poor human rights records.

Pound cost averaging

Pound cost averaging is a sound strategy for reducing risk as part of long-term investing. It involves spreading the purchases of an investment across several months and so is most suitable for collective investments.

With pound cost averaging it is less likely that you will buy shares at the very top of the market. Sometimes you will buy at a peak, but over the longer term, it's also likely that you will buy in a trough. And when buying in a dip, you purchase disproportionately more stock, reducing the overall book cost of the holding.

Trading

Many people who invest in the stock market trade to a certain degree. Profits are taken at opportune moments even where the company's long-term prospects are sound. Where the market is fluctuating, it is often sensible to take short-term positions. Clearly, actively managed portfolios will involve a greater degree of trading than more passive approaches. Indeed, a degree of trading makes investing more enjoyable and fun.

However, trading as a serious strategy differs from investing. Investors are concerned with the longer-term profitability and prospects of a company, while traders tend to attempt to profit from short term movements in the price. While they might use some of the techniques of the investor, the process is different and requires at least semi-professional market skills.

With a great deal of time, attention, resources, risk and effort, traders can take advantage of movements in share prices which move constantly during market hours. Such specialised skills and effort are not required for successful investing strategies.

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All investors should review their portfolios periodically. Active investors will conduct this exercise on a more frequent basis but passive investors should consider their list at least annually. You need to ask yourself a number of important questions.

- Is any individual stock oversize?

Where a company has grown rapidly it may be time to 'top slice' the holding, just reducing it in line with the typical unit size of the portfolio. Where a company's share price has doubled, it is worth considering whether half of the holding should be sold.

- Is the list over-exposed to one or more sector?

If the portfolio is overly reliant on the fortunes of one business type, it is not sufficiently diversified. Some degree of re-deployment may need to take place.

- Are there important sectors where the portfolio has little or no exposure?

It may be necessary to invest in choice stocks in sectors likely to prosper.

- Are the levels of income and growth sufficient?

Re-examine your investment objectives.

- Is the level of risk displayed by the portfolio about right?

If risk is too high, the portfolio will need to be re-structured to reflect your attitude. Conversely, too low level of risk may affect growth prospects.

- Poorly performing stocks should be re-assessed for quality and prospects.

You should re-visit your original rationale in light of developments. It may be necessary to cut losses before the situation deteriorates. In other circumstances, you may conclude you are still right to have purchased a particular stock and may even want to buy more while the price is at a low.

- Are any of the securities, such as Zero Dividend Preference stocks and gilts, due for redemption or recently repaid?

You will need to decide what to do with the proceeds.

- What about the market conditions?

Is the portfolio structured appropriately or should defensive or indeed more aggressive stocks be considered?

- In the approach to the tax year end (5th April), you should ensure that the portfolio is as tax efficient as possible.

Are there any gains that could be taken to make use of the CGT allowance? This can be important in future years by reducing large in-built gains which may attract large tax liabilities if sold. Has the portfolio exceeded the allowance, if so are there any losses that can be taken to mitigate the gain?

- Where the portfolio contains cash from proceeds and dividends, you will need to consider re-investment.

Here, similar factors will apply. Are there companies or sectors which require topping up? Are there buying opportunities in existing or companies new to the portfolio? Are there forthcoming new issues of interest?

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Please bear in mind that the levels and bases of taxation can change. The explanation below is for general information and should not be relied upon as a source of taxation advice. The extent and value of any tax rates, advantages or benefits will vary according to an individual's circumstances.

Tax is one of the most important issues for the investor. The tax year in the UK ends on 5th April and transactions and income derived during the year to this day that must be assessed annually.

See the Tax Card for current rates and allowances.

There are two types of taxation which primarily affect investors, income tax and capital gains tax.

Income Tax

Income tax is charged at the marginal rate on any dividends or distributions received. Most dividends are paid net of 10% tax.

Capital Gains Tax

Capital Gains Tax (CGT) can be very complicated and this section is only intended as an introduction. An accountant should be involved if you are unsure of your liabilities.

CGT is liable at the marginal rate on any gains realised during the tax year, in excess of the annual exemption. This includes sales and return of capital for example in the form of redeemable 'B' shares. This is where a company realises assets, for instance selling part of its operations, and returns the cash to shareholders.

Losses

Any capital losses taken during the year may be offset against capital gains to reduce the potential bill. Overall losses may be carried forward but if the allowance remains unused it is lost. Making as full use of the annual exemption as possible is considered sensible tax planning as this is one of the few tax breaks available to investors.

Gains

Can mount to a significant level over time and taking advantage of the annual allowance can save a lot of money in the longer term. It used to be possible to "bed and breakfast", where a stock was sold one afternoon and re-purchased the next morning in order to create a paper gain or loss, thereby taking advantage of the allowance. This practice was stopped by Chancellor Gordon Brown.

Bed and ISA:

You can "Bed and ISA" where stock is sold and re-purchased in an ISA. However, the ISA must be funded and there is a limit on how much may be subscribed. Alternatively, stock may be sold by one spouse to be re-purchased by the other.

Gifting

shares to family or friends is considered as a disposal for capital gains tax purposes with the donor liable for tax based on market value on the day of proposed transfer. The book cost allocated to the new holder will be this value assigned to the disposal. Spouse transfers are permitted without incurring tax liabilities. This makes it possible to make full use of both allowances. However, these also transfer the original book cost and history.

ISAs

Investors should consider the suitability of opening an Individual Savings Account (ISA). ISAs are essentially tax efficient environments into which stocks can be placed. Gains realised within this environment will not attract CGT. Most longer term investors can benefit from holding an ISA. As compounding has demonstrated, it is not only the large investor who can build a large portfolio.

PEPs

ISAs replaced PEPs in April 1999. PEPs may still be retained and investments altered but no new funds may be introduced. If you already have a PEP, it may form a sizable part of your overall investment portfolio. For this reason, continued attention should be paid to its contents and the portfolio should be reviewed periodically as with the rest of your investments. Although no new funds may be introduced, there is no limit as to the potential growth of the investments. Remember, all gains are tax free.

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