“Non-fund” selection

For the more experienced investor, there inevitably comes a time when he or she will want to put their stock selection skills to the test and adopt the role of a fund manager and invest directly in non-collective stocks.  There could be a number of reasons for this:

Advantages

It could be cheaper – avoiding the internal costs of a fund

Allows targeted exposures to particular sectors and/or individual companies

Performance could be very different to the market in a good way!

Disadvantages

More risk/volatility

Harder to diversify

Should involve more research and monitoring

Performance could be very different to the market in a bad way!

Many investors, particularly relatively new investors, may be encouraged to adopt this approach because of some “tip” they may have read or heard about in the investment media.  All too often this is some highly speculative small company stock promising fantastic returns to anyone who can ‘climb aboard’ before the company takes off. Although such stocks can exist, they are very rare indeed.

A better approach is to restrict your initial or the bulk of your investments to more established, larger companies with some “satellite” holdings in smaller company stocks.

Investing in larger companies

Advantages

Generally ‘safer’ than investing in smaller companies as they are more established.  However, large companies are not immune from collapse or price shocks eg Northern Rock, Royal Bank of Scotland, BP

Lower trading costs – smaller ‘bid-offer’ spread compared with smaller companies

Good marketability – easy to trade in large volumes

Often available via regular investment – many brokers offer a regular investment plan for larger companies at low cost. For example, AJ Bell allows investors to drip feed money into FTSE350 companies (and a range of investment trusts and ETFs) with commission on purchases of just £1.50.

Disadvantages

Lumbering giants – the sheer size of larger companies means that they are won’t have the potential for significant growth that is enjoyed by smaller companies

Well researched – the fact that hundreds of analysts are constantly researching such companies on behalf of the city institutions means that share price ‘anomalies’ (ie where the share price fails to reflect the value of a company relative to its peers, sector or the wider market) are less likely to occur.

How to identify ‘larger companies’

In the UK, the largest companies are constituents of the FTSE100 index.  Many of these will be household names, although the index is increasingly made of international companies which choose to list here.  Larger companies are often referred to as ‘blue chip’ companies, a reference to the most valuable chips used in casinos which are coloured blue.

The next ‘tier’ of companies in size below the FTSE100 make up the Mid-250 index.  The FTSE100 and Mid-250 combine to form the FTSE350 index.

As the market capitalization of individual companies varies – by changes in share price or the issue of new equity, for example – so does their ‘ranking’ in size.  This means that companies can join or exit the indices over time.

Note:

At this point it is perhaps worth pointing out that certain investment trust companies can themselves be constituents of the FTSE100 or Mid-250 indices.

Investing in smaller companies

Advantages

Offer a greater potential for growth

Under-researched – there is more chance for share price ‘anomolies’

Disadvantages

Risky – smaller companies are likely to be less established than larger companies and are therefore more vulnerable to poor trading conditions in their sector or the wider economy.  They may also be much more dependent on one or two large ‘customers’

Poor marketability – greater ‘bid-offer’ spread

Volatile share price – the share prices of thinly traded stocks can be significantly influenced by a few large trades

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