For investors who are just starting out on their investment journey, the local share market is often seen as a good starting point. In fact, while Australia makes up just over 2% of the global share market, most Australian investors are heavily biased towards their home market. In almost every global market, investors tend to hold a home bias.
In Australia, there are many reasons why this is the case – a preference for familiar local brand names and businesses, the tax treatment of dividends and an aversion to the currency risk which can arise from investing in overseas markets.
The performance of the Australian share market in the last few decades is also a key reason for the investor home bias. The Australian economy had experienced 27 years without recession in January of 2020, the share market set a new record, with the S&P/ASX 200 breaking through the 7,000 mark for the very first time. Then COVID-19 entered the scene and placed the economy under significant pressure. Well diversified portfolios performed much better than a portfolio of say energy stocks as the oil price hit historic lows.
Getting started with trading
When buying and selling shares, you will need to trade with a broker. This could be a full-service advisory broker who recommends individual stocks to buy, or a lower cost online broker such as Bell Direct where you decide which stocks to buy.
You may choose to purchase shares in individual companies you have selected yourself, such as Commonwealth Bank (ASX:CBA), BHP (ASX:BHP), Telstra (ASX:TLS) and Woolworths (ASX:WOW). Alternatively, you can also invest in a ready-made portfolio through Exchange Traded Funds (ETFs), which provide access to an entire index (i.e. the ASX200).
Before making any investment decision, it is important to consider your individual investment goals and timeframe (covered in part one of this series).
For example, if you are a young investor who is primarily seeking capital growth and prepared to take on some risk to achieve it, you will likely purchase very different assets to a retiree who is seeking regular income and capital stability from their portfolio.
However, before trading on the Australian share market, it’s important to understand its unique characteristics.
The local taxation environment
One of the key benefits of investing in Australian shares is franking credits.
Franking credits are a type of tax credit designed to prevent ‘double taxation’. The Australian Taxation Office (ATO) recognises that corporate tax has already been paid on a company’s profits, which are distributed to investors as dividends.
Once the company tax has been paid, dividends are franked (stamped). Shareholders then get a tax credit for the tax the company has already paid in Australia.
Franking credits are attractive to many investors because if the franked dividends are higher than their marginal tax rate, this could result in a tax refund at the end of the financial year.
For investors at the start of their investing journey with a long timeframe, an effective way to create wealth is to automatically reinvest your dividends, instead of receiving the cash payment – this, which is called a dividend reinvestment plan (DRP), can be easily set up via the registry of the investment (such as Computershare or Link Services). Under the plan, any dividends paid are used to buy additional units in the company or ETF, overall increasing your stake in the particular investment and ultimately supercharging the power of compound interest.
Lack of sector diversification
There are, however, some downsides to focusing a portfolio solely on Australian equities. One of these is that the local market is heavily weighted towards a very narrow set of industries.
For example, the S&P/ASX 200, which is made up of Australia’s largest 200 companies, financials account for around 28% while the materials/ resources sector is 20%. That’s almost half the index in just two sectors.
If you are looking to create diversified portfolio, you may therefore wish to look offshore to tap into global opportunities. This can help to provide both sector and geographic diversification, helping you to spread investment risk. We will investigate this area further in part four of this series.