Most people who invest their money for the long-term decide they should own some shares (or equities, as they’re also called).
This is a good idea. Over the past 116 years, the UK stock market has historically delivered an average after-inflation return of 5.5% a year.1
In comparison, bonds have returned on average just 1.8% after-inflation over the same period, and cash a puny 1% a year.
So shares look like a winner when it comes to money you plan to tuck away for long-term growth, such as in a pension.
But what is a share?
What a share is
Shares denote slivers of ownership of companies.
By owning a slice of a company via its shares, you’re entitled to a portion of the wealth that the company generates over time.
Your particular entitlement varies with the size of your stake – in other words, the number of shares in the company that you own.
Western economies have tended to expand over the decades (boosted by inflation).
This economic growth has been reflected in the performance of our publicly owned companies, which in aggregate have become much more valuable over time.
As a result, shares have provided the best gains for investors over the long-term compared to the fixed returns from assets such as cash and bonds.
Share prices can go up and down
To be clear, the shares we’re talking about here – shares in public companies – are those traded on the stock markets.
Such trading means that as well as often receiving an income from your shares – called a dividend – you can also sell your shares in the future. Hopefully at a higher price than you bought them for!
This combination of dividends and capital growth is how shares deliver their returns to investors.
However it’s important to realize that the value of shares does fluctuate both ways – that is, their prices go down as well as up.2
In a stock market crash in particular, share prices can fall a lot.
Hitherto most Western markets have eventually bounced back, even from big slumps like we saw in 2008. This has rewarded investors who sat through the crashes rather than selling.
Nevertheless, until prices do recover your wealth has been reduced – even if you prefer to think of it as a paper loss because you haven’t sold.
Such volatility (and uncertainty) is what makes shares riskier investments than cash or bonds.
You simply don’t know what your shares will be worth on any given day or month, even if you believe that over the long-term you’ll be rewarded for owning them.
And when prices do fall, it can take years for them to recover.
Look at this graph showing how the UK stock market has behaved since the year 2000:
As you can see, since 2000 investors in the UK market have had to endure two big declines. There was a slow slide from 2000 to 2003, and a sharper slump around the financial crisis, beginning in 2007.
Indeed, if this graph were the only evidence you were ever shown about investing in shares, you might wonder why you’d bother.
The level of the market today (right hand side of the graph) is not hugely higher than where it was in 2000 (left hand side), even after enduring all those ups and downs.
Some reward!
It’s important to note though that this graph, like most stock market graphs you’ll see, only shows capital growth. It doesn’t include the dividend income I mentioned.
Dividends are worth about 3-4% a year from the UK market. The total return picture is much more attractive if you assume dividends paid were reinvested back into the market every year.
We saw that in the historical return figures I quoted at the start of the article, which do include dividends.
Also, even 17 years is only really just getting into the ‘long-term’ when it comes to shares.
For a wider perspective on how shares can deliver strong gains over time, here’s a graph of how the US market has performed since the late 1970s:
Since 1977, the US stock market is up more than twenty-fold. Again this does not include dividends, which would have massively boosted those capital returns if reinvested.3
I know that 1977 may seem a very long time ago, particularly if you’re young.
But if you’re in your mid-20s, say, then you’ll probably be saving for your retirement for 40-odd years. Forty years would take you back to 1977, where many people like you began investing in US shares for their own retirement.
Certainly there would – in retrospect – have been better and worse times to invest over those long four decades.
But the main thing to notice is the pattern of slumps and recoveries. This is what you have to steel yourself for when you invest in shares.
Don’t lose it entirely
It’s also important to note we’ve been looking at overall stock market movements so far.
Put simply, when we say ‘markets’ in this context, we’re referring to the shares of all the companies listed and traded in a particular country.
So the UK market refers to the shares of companies listed on the London Stock Exchange.
Data providers further divvy these shares up into various stock market indices. These indices makes it easier to track the performance of groups of companies, among other things.
For instance, in the UK we have the FTSE 100, which is the index of our 100 largest listed companies.
We also have indices that track the shares of energy and mining companies, indices of smaller companies, property companies, and so on.
Now, when I say markets have always bounced back from the worst crashes, that’s true in all but a handful of cases.4
But individual companies, in contrast, can and do go bust. And when a company goes bust, its shares can become worthless.
If you’re an investor in a company that goes bust – or one that simply goes down a lot in value and you sell, for that matter – then you will lose money.
There’s no compensation schemes or other protections in that case.
When you buy shares you are a true investor in a business venture. And when the business goes bust, the venture did not turn out well.
Diversify your shares
We see a picture then where stock markets overall have tended to post great long-term returns, even though some of the companies trading on those markets have delivered diabolical results.
In the worst cases big companies have gone bust, and their shares have become worthless.
What is happening here?
The seeming contradiction is simply down to the strong returns from the very best performing shares more than making up for the terrible returns of the worst.
- The most value that can be destroyed when a company goes bust is 100%.
- But if a business does very well or becomes very popular with investors (not always the same thing) it can go up in value by 200%, 300%, 10,000% or more.
This wide variation of returns from individual shares – together with the risk of permanently losing your capital in any that fail – is why it’s super important to diversify your holdings across many different companies.
Fortunately this is nowadays easily done.
The easiest way to invest in shares
As we’ve seen, deciding you should own some shares only opens another can of worms!
Besides preparing yourself for the market’s ups and downs, you might also consider:
- What amount of shares is it best to own for your age, income, aims, and attitudes towards risk?
- How do you decide which shares to own?
- What’s the best way to own them?
We can’t answer the first big question in this short piece, but other Monevator articles can help you create your own plan.
However for the other two questions, we’re convinced the simplest way for most people to own shares is via a global equity tracker fund.
Such a fund holds small stakes in many thousands of companies all over the world. This hugely diversifies your investments – not only across different shares, but also across different countries, currencies, and business types.
And as a tracker fund, it’s a low-cost passive investment that will leave more of your money free to compound over time.
- Before you invest you should read more about the benefits of a global equity tracker fund.
- We’ve also written about how to choose the right global tracker fund.
For much more on passive investing in general, head over to our passive HQ.
Key takeaways
- Shares are slices of ownership in publicly traded companies.
- Over the long-term, the returns from shares have outpaced those from bonds and cash.
- Share prices can go up and down, and in the worst case you can lose all your money.
- Overall though, stock markets have tended to go up over time.
- Diversifying your money across the shares of many different companies helps protect your investment from the worse outcomes.
- A global tracker fund is a cheap and effective way to invest into a diversified portfolio of global shares.
This article about shares is one of an occasional series on investing for beginners. Please subscribe to get our articles emailed to you and you’ll never miss a lesson. Why not tell a friend to help them get started?
- My data here on returns for UK shares, bonds, and cash all comes from the Credit Suisse Yearbook 2017. [↩]
- To a lesser extent the dividends they pay are volatile, too. Dividends can be reduced or even cancelled by a company if it hits hard times. [↩]
- Unfortunately most graphs of stock market returns don’t incorporate the impact of reinvested dividends. [↩]
- The most important exceptions are Russia, China, and Germany, where markets were disrupted by revolution and war, and Japan, which is still well below the peak it reached in the late 1980s. [↩]
Comments on this entry are closed.
Great read. I must confess though, the conclusion I reached was to identify good companies that I want to part own and invest in those rather than invest in a tracker. I do understand that what spoils it for the former approach is the cost benefit ratio of doing that, and that the dimension of the share price also impacts the outcome. But the thought of going to a largely rule-agnostic tracker to achieve part ownership in all companies feels extreme. Something has to give, maybe we will have smarter betas & cheaper active investing someday that take both stock & sector fundamentals and technicals into account in deciding to invest and stay invested.
Words of caution for the beginner:
“the UK stock market has historically delivered an average after-inflation return of 5.5% a year”: the investor would have lost much of that gain to (i) charges, and (ii) taxes. So he needs not only to diversify, he needs to use cheap forms of assets, cheap trading services, and tax shelters.
Edited quotation:
“In comparison, cash has returned on average just a puny 1 % after-inflation over the same period”. The beginner should be wary of such a sweeping statement. Investment managers are prone to measure the return on cash by the ‘puny’ return on Treasury Bills. The retail investor, however, can routinely get higher returns on cash and can, moreover, get them tax-free.
The consequence can be that the gap between the return on shares and on cash, although still favouring shares, may often be distinctly narrower than commonly argued by investment managers.
Why, oh novice, would those kind, generous investment managers set out to mislead you? Incentives, deah boy, incentives.
I started investing in indivdual shares but quickly realized a low maintenance tracker was the way forward. I was spending time trying to judge how good a company was (no idea really) and taking risks with the ‘next big thing’ that flopped. Even when I made money I realized if I had held for longer I would have made a lot more money so still beat myself up. I was starting to day trade, I was impatient for quick returns, I got emmotionally involved in my picks.
Nah, simple tracker means I sleep at night and I can keep the distance needed for long term investing. Reading about this company or that company that has this good news or that bad news no longer turns my stomach.
I notice you have used log scales in your graphs. Although there are good reasons to use log scales, perhaps a linear scale would be more useful to a beginner. I think that only a minority of people are really going to understand why you are using a log scale, and they aren’t the ones the article is aimed at.
I think I can spot at least one comment that is heading for deletion. 😉
@Andy — Hah! 🙂 I think you’ve made a very good point, and I did actually consider not using log scales. Perhaps I’ll swap them.