When you buy a share, you receive a share of the company’s ownership and value.
Ownership of a share gives you the right to a portion of the company’s assets and earnings, and a say in its running.
What your right to a voice means in practice is that you will receive a vote for every share you hold, to be used at annual meetings – although your vote is likely to be insignificant next to those of the large investors in the company.
Your right to assets means that if the company goes bankrupt, you will receive a share of what remains after creditors have been paid off.
Your right to profits means that you have a right to a portion of the dividends that the company pays out.
A company does not have to pay out a dividend, but it has the choice. It is a set payment to shareholders per share they hold, paid out of retained earnings.
Why should you invest in shares?
Data from FE Analytics
shows that the FTSE 100 index of the country’s largest companies grew by 1,221.48 per cent between 1 January 1986, when our data begins, and 31 May 2013.
This means that if you had invested £10,000 at that time, you would have more than £100,000 now – and this is in spite of the Wall Street crash, the dotcom bubble of the early 2000s and the financial crisis in 2008.
Equities offer more potential for growth than the other assets available to the retail investor, albeit at a greater risk.
A business could begin in a founder’s garage and end up a multi-billion pound international market leader – as happened to Microsoft. In that case, the potential gains are enormous.
In recent years, during a protracted period of financial crisis, investors have piled into bonds, causing them to become more expensive and equities more attractive as a result.
This means that even investors with a lower appetite for risk have had to consider buying stocks and it is likely this will continue for some years to come.
Equities are also more liquid than other assets, meaning it is easier to buy and sell them, which appeals to investors who like to trade directly.
Investing for dividends – or income – is a key motivation for many investors, not just those who want to draw the income, but also those who want to reinvest it to boost their capital gains.
FE data shows conclusively that reinvested dividends make up a huge proportion of long-term returns from the stock market. What are the risks?
The volatility of stock markets is their big drawback, which is why investing in equities is usually for those with a time horizon of at least a number of years.
Each of the three events mentioned earlier saw large losses in the markets as a whole, but the long-term gains show that if you stay invested through the bad times, you can make a lot of money.
You need to be prepared for periods in which markets go down and in which markets are very volatile, to invest in this asset class.
This volatility means that the asset class typically suits an investor who is younger or who has a higher appetite for risk.
The converse side of the growth potential of companies is that they can collapse from a seemingly strong position into bankruptcy – as shown by a number of famous UK high street chains in the last few years. If that happens, a shareholder could lose all of their money. How should you invest in shares?
Investing directly in stocks can be extremely tempting. However, professional fund managers have far greater resources than the average private investor and far more time to spend on research, meaning they are likely to have the edge over you.
However, some investors do like to look for stocks that are underappreciated by the market, particularly among smaller companies, which do not receive as much coverage by large financial institutions.
The biggest advantage investing in funds brings is their diversification. A fund may hold between 50 and 100 stocks, meaning that the consequences of any single company having a bad period is reduced.
The price of an equity depends on what other people are prepared to pay for it – in other words, it is largely determined by sentiment, which means that individual stocks can be driven by irrational or erroneous beliefs.
Drip-feeding, or paying a regular monthly amount, into equity funds can help to cope with market volatility. Research has shown that it produces better returns over the long-run than trying to time the markets and investing when you think they are going to go up.
Diversifying equity holdings also helps, both in terms of geography and sector. This should help to ensure that all of your funds don’t go down at the same time.