What are shares and how do they work?
Investing in shares can appear daunting to the beginner. Here we outline how shares and equities work, how to buy them, and outline the risks involved in owning them.
What are shares and equities?
Shares, or equities, are simply units of ownership in a company. Owning a share will allow you to participate in share price growth (assuming the shares rise in value), receive dividends and to vote - should you so wish – on resolutions at the annual general meeting (AGM).
In the UK most shares are listed on the London Stock Exchange (LSE) or Alternative Investment Market (AIM). These are merely venues for trading shares in companies, but there are also some special rules that different listings can confer. For example, some AIM-listed shares can be exempt from inheritance tax. From a practical perspective, it makes little difference to you, the process of trading a share through a share dealing platform is the same no matter which exchange it sits on.
How do shares work?
Most companies start life under private ownership, which is to say that they are not listed on a stock exchange. They may be funded by individuals at first, and once the business model is proven seek to grow further by seeking investment from venture capital or private equity firms.
An initial private offering (IPO) would see a firm look to list on the stock market, which could be desired for a variety of reasons. An IPO can raise a firm’s profile, provide an exit opportunity for early backers, or be used as the means to tap public markets for more equity, giving the business the chance to gain further market share.
Equity owners seek two types of return from their investment: capital growth and dividends. As a company’s value increases, so should the price of its shares, which might then be sold for a profit. The opposite is true if a company’s value decreases; the shares will drop in price and may have to be sold for a loss.
In general, more mature businesses will pay out a portion of the company’s profits in the form of a dividend. For example, Apple was for years perceived to be a growth company, and it re-invested its profits to generate further gains for shareholders. Now that it is more mature, it has started to pay out profits as a dividend. The UK market has for years been the source of high dividends, with many companies looking to increase their pay-out year after year.
Nevertheless, it’s important to remember that businesses that pay dividends are not a source of ‘free money’ as when a company goes ‘ex-dividend’, its share price will fall by the same amount as the dividend paid. In fact from a shareholder perspective, it can be tax inefficient to receive dividends. You should also consider whether a company can afford to pay a high dividend, as these are often come hand in hand with weak share prices and future distress.
How many shares are there in a company?
The number of shares in any given company will vary greatly, and really is of little importance to investors. There may be millions or even billions of shares making up a company’s equity capital.
A common mistake is to look at a share price, which might be £20, and to judge that it is expensive vs. a share costing £10. What matters is the earnings of the business. A £20 share with earnings per share of £2 has a price earnings ratio of 10x, while a share priced at £10 with 50p of earnings has a price earnings ratio of 20x.
Similarly, a company share that costs £20 now vs. £10 three years ago could be cheaper if the earnings have gone up by more than the share price.
Why buy shares?
People buy shares as they represent the best way to participate in global economic growth over the long run. They are riskier than cash in the short term, but for most people your main risk is retiring without enough money for a comfortable lifestyle. Cash has historically been a poor way to generate long term returns as your deposits can be eroded away by inflation.
Equities should always be a better bet for long term gains, which makes sense when you think about it. When an economy reports GDP growth, it reports that number on a ‘real’ basis, which is to say that if nominal growth is 4% and inflation is 1.5% then the real growth of the economy would be 2.5%. If there is economic growth, businesses should see the value of their assets increase in line with inflation and they will also be able to pass inflation linked price rises through to their customers. A growing economy should result in owners of assets steadily getting richer, while those without assets will see no change to their circumstances.
Over the past 100 years, UK equities have generated returns of 5.5% a year over and above inflation, meaning that the real value of your investment should double every 13 years. Over a 30-year time period, you might be able to turn £100 in £500 if equity markets perform as they have historically.
How to invest in shares
To trade shares, you need to open an account with a share dealing provider such as IG. You can choose to either buy a fixed number of shares (say 100 shares of Vodafone), or a fixed value (perhaps £1000 of Vodafone).
Once you have bought the shares, you own them. Your platform will segregate your assets in a third party custodian account, so that in the unlikely event it goes bankrupt, you still own the shares.
When you buy and sell a share, you are not buying it from your share dealing provider. Your platform provides the technology to seek quotes from a number of stockbrokers, automatically offering you the best price. This is known as trading 'at quote', where you will be given 15 seconds to accept or decline the price.
The alternative to trading at quote is 'on exchange', whereby you choose the price you would like to deal at. This can sometimes be a better way to buy and sell small cap stocks with wide dealing spreads.
What are the risks of buying shares?
Your main risk in owning shares is that individual companies get into difficulty and go bankrupt or suffer large share price falls.
This can be avoided by either spreading your exposure across a large number of shares (typically twenty or more), or by getting diversification through buying ETFs. You can find our more in our article, how to understand exchange traded funds.
That said, investing in the equity market can still result in sizeable short-term losses in market sell-offs. For people wanting to manage their risk, an asset allocation that invests across different asset classes such as bonds, property and commodities, can deliver a smoother return profile and reduce your risk.
IG Smart Portfolios are designed for this purpose, taking into account both your time horizon and the amount of risk that you are comfortable taking on.