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Investing for beginners: What is a share?

Posted By The Investor On In Investing | 5 Comments

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 [1] delivered an average after-inflation return of 5.5% a year.1 [2]

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 [3]).

This economic growth has been reflected in the performance of our publicly owned companies, which in aggregate have become much more valuable over time [4].

As a result, shares have provided the best gains for investors over the long-term compared to the fixed returns from assets [5] 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 [6] – 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 [7]

In a stock market crash [8] 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 [9] (and uncertainty) is what makes shares riskier [10] 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:

A chart of the FTSE All-Share since 2000 [11]

The FTSE All-Share index from 2000-2017. (Click to enlarge)

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:

[12]

US S&P 500 index, from 1977 to 2017. (Click to enlarge)

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 [13]

I know that 1977 may seem a very long time ago, particularly if you’re young [14].

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 [8], that’s true in all but a handful of cases.4 [15]

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 [16] 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 [17], 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.

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 [18] 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:

We can’t answer the first big question in this short piece, but other Monevator articles can help you create your own plan [19].

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 [20] over time.

For much more on passive investing in general, head over to our passive HQ [23].

Key takeaways

This article about shares is one of an occasional series on investing for beginners [24]. Please subscribe [25] to get our articles emailed to you and you’ll never miss a lesson. Why not tell a friend [26] to help them get started?

  1. My data here on returns for UK shares, bonds, and cash all comes from the Credit Suisse Yearbook 2017. [↩ [30]]
  2. 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. [↩ [31]]
  3. Unfortunately most graphs of stock market returns don’t incorporate the impact of reinvested dividends. [↩ [32]]
  4. 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. [↩ [33]]