Why I trust shares above all else

I hope you have been enjoying the DIY series of Penny Sleuths, and you now feel more comfortable taking control of your own wealth. Today, I want to talk about the most important decision for an independent investor what should you buy?

If you have been paying attention to this short series on DIY investing you should now be familiar with some of the online brokers and have considered the type of portfolio account that would suit you best. But now we get to the interesting bit! Assuming you have opened an account and funded it with some cash, what do you actually invest it into?

TD Investing, for example, offers you the following alternatives: UK stocks, international stocks, bonds and gilts, investment trusts, funds, exchange traded funds, real estate investment trusts, covered warrants, company warrants, foreign exchange and savings accounts.

Barclays Stockbrokers, for good measure, also throws into the pot exchange traded commodities, structured products, contracts for differences, financial spread trading, turbos and new issues.

Confusing isn't it?

But then the financial services industry likes it this way. Because the more confused we become, the more we will chop and change our portfolio or feel inclined to pass the whole matter into somebody's else's hands. That, of course, is how the industry makes its money at our expense.

So let's just get down to basics.

How to create wealth as an investor

Wealth is created by the combination of labour, raw materials and financial capital to produce goods and services that others are willing to pay for. The public sector contributes to wealth creation by, for example, providing valuable education and transport links.

But for investors the way to benefit from this process of wealth creation is to buy a share of a private sector business that is able to sell something for more than it has cost to make. This does not have to be a tangible product; although manufacturing is politically in vogue it is not intrinsically any different in terms of value creation to a service such as plumbing or running a cinema. All of these endeavours have costs, but also create value if customers are prepared to pay a price that exceeds the cost of production.

I apologise if this sounds like an economics lesson, and you may think it is all quite obvious. But an appreciation of the basis of wealth creation is absolutely critical if you are going to become a successful investor.

To simplify matters, a successful business will have costs of two plus two and sell its product for a revenue of five. That gives it a profit of one that it can use to expand the business in the future. (I'll point to two very successful outfits later on one is a software star, the other a tremendous engineering group). If you buy shares in these companies, their abilities to reinvest this profit to make more profit in the future is the mechanism by which the value of your investment will grow.

This is pure investment. By investing directly into company shares you get right to the heart of the process of value creation.

Three categories I steer clear of

Other popular categories remove you from this. For example:

Funds

UK savers are certainly spoiled for choice here. They can choose between thousands of funds. Most go under the name of unit trust' while a slightly different type is the investment trust.' Then there are exchange traded funds', real estate investment trusts', hedge funds' and more.

All of these have professional managers who levy the very charges that, through DIY investing, we are trying to avoid. They all purport to diversify risk' by holding a mix of, for example, company shares; and to add value' by their judicious selection. These claims are dubious at best and are simply not worth the management charge.

Derivatives

A derivative is a financial instrument that is linked to another. For examplean option' gives you the right to buy an underlying asset, which might be oil or gold. There may be reasons why it makes more sense to buy the derivative rather than the underlying asset, but the point is you will pay for this deemed benefit. A derivative is one step removed from the thing that you really want to get at, and financiers charge you for creating the mechanism.

Tangibles

In this category I would put residential property, wine, fine art, gold, silver and all commodities. None of these are genuine investments, in my view, because none of them creates wealth. Instead, they are the things that the genuine wealth creators choose to spend their money on, and so are also a step removed from the real fount of wealth creation. Although it is possible to derive some value from them by renting them out, if you leave any of these things alone for any length of time they will stay the same or deteriorate. By contrast a successful business is a living thing that will thrive and grow over time, and multiply your investment as it does so

Where I trust my money

That just leaves one category.

Money lending

Whether we deposit money in the bank, or buy government or corporate bonds we are lending our money to another in return for a rate of interest. This is an entirely valid and essential component of the whole process of value creation and it is a good way of making a financial return.

As I said earlier the financial scene can be very confusing. I like to make it as simple as possible. So I stick to either lending my money to somebody I can trust in return for a rate of interest; or I get as close as possible to the true source of wealth creation.

That is by investing directly into shares. But to whom should we lend our money, and which shares should we pick? That is a subject for next week.

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Information in Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd.