Every FIRE and personal finance article ever will tell you about the importance of investing in the stock market, but what is a share, and why would I want to buy one?
You can definitely invest in the stock market without this knowledge, but you’ll feel pretty stupid if people know you own share but you can’t give them an answer when a kid asks you: “What’s a share?“
This post covers the basics, made simple: what is a share? Why would I want some? What are the risks and benefits?
The shares referred to in this post are publicly-traded shares. You know, the ones on the stock market. It’s also possible to own private equities in limited companies… but that’s a whole other story.
When most people think of the stock market, they’re expecting a bunch of numbers, some scary graphs and lots of white men in suits shouting “Buy! Buy! Sell!”.
Of course, that’s not actually what a share is.
A share is a portion of a company: a right to a share of profits and a claim to a portion of the assets if the company is wound up.
Simple, eh? If you buy a share in a company, you own a bit of it.
Well, yes and no. This is exactly enough information to be dangerous. There’s a bit more to know.
How many shares make up a company?
As many as the company wants to issue. Oh, yes. There are rules for how many new shares can be issued by publicly traded companies (i.e. the ones you see on the stock market) in a year, but in theory they can have as many as they want.
What that means for you is that unless the company actually gains more value – maybe by making more money, maybe by owning more stuff – then the value of a share should go down. This is because there are more shares to claim the same stuff, so each share is worth a smaller piece of the pie.
Voting rights?!
Shares often – but not always – come with a right for the owner of the share to vote at meetings.
Public companies, such as the companies listed on the London Stock Exchange, have to have an Annual General Meeting. If you own shares in a company, you get a right to attend and vote.
Sadly, the amount of shares you own is probably going to be tiny compared to big, institutional investors. A lot of pension funds, banks, eccentric billionaires or whatever own the biggest chunks of public companies.
So, you might have a vote, but don’t let the power go to your head. You probably own less than 0.1% of this huge, publicly-traded corporation.
What’s the point?
Companies issue shares in themselves to raise money to buy stuff and do new projects.
By issuing (i.e. making and selling) bits of themselves, they don’t need to take on too much debt.
When a company issues shares, it has a few options. It can issue them privately to a select group of investors in a placing; it can offer them up to exisiting shareholders in a rights issue; or it can go straight to the wide world and offer shares to anyone who wants to buy in an open offer.
You should note that if you own shares in a company and it issues more, your holding is diluted. Big institutional investors hate that, but as a private investor you’re probably holding so few that it’s not the end of the world. A further issue of shares might indicate that the company is going places… or it might indicate that it’s broke and needs cash. Anything is possible!
Shares themselves are split into a share reserve price and a premium. By the time you see them on the stock market, you’re buying them second-hand, so it makes no difference to you as an individual. The important bit for the company is that the share reserve counts as security for its current debts and the premium is a big pile of cash that it can spend on projects.
Companies basically run on debts and flows of cash: a balance of money coming in and money coming out. This brings us nicely to our second point…
Why would I want some?
Companies exist to make money for their owners. That’s it.
No, really. They’re neither good nor bad. They’re just one big agreement of human and financial capital thrown together to make money for the people who own it.
It’s a bit of the company. If you buy one, you’re one of those owners!
This means that every time someone buys your company’s products, technically they are making you richer. It is actually pure passive income from this point on… assuming it makes profits!
Your money can grow through both capital appreciation and dividends. Don’t worry, it’s easier than it sounds.
capital appreciation?
When the actual value of a company – its resources, its contracts, its cash in the bank – grow, so should the value of your shares.
Pretty sweet, eh?
However, you’ll note the should. Shares are sold on the stock market, so hype plays a big part in the pricing. More on that later.
If you buy a share for one price, then sell it for more, you’re making a capital gain. At the time of writing, if you make more than £12,000 from capital gains on all of your investments in a year, you owe capital gains tax to HMRC. However, £12,000 a year is a lot, and if you buy shares in an ISA they get ignored by HMRC – completely legally.
Capital gains are only taxed when you sell, and only for the difference. This means that if you just hang onto shares, they don’t get taxed yet. It also means that you need to be making £12,000 of profit from the sales that year before you pay tax, not just selling £12,000 of stuff.
Dividends?
Traditionally, a company pays out some of its annual profits to shareholders in cash. This payment is called a dividend: it’s a partial return on your investment in the company.
The catch is, companies don’t have to issue a dividend. If they’re paying you, they aren’t using their money to invest in new products, services or projects with that money.
A lot of companies now don’t issue dividends. Tech companies, in particular, don’t issue any dividends because it looks like they’re running out of ideas.
Choosing when to issue dividends or not is a big tactical call for companies. This idea is called signalling. What does issuing a dividend tell your investors about your company?
On the plus side, using dividends means that you can buy shares that make you passive income. It’s completely possible that you end up owning so many shares that their dividends make you financially independent… but putting all your eggs into one basket isn’t a good idea. I’m a big believer in diversifying across lots of different types of asset.
What are the risks and benefits?
Now you can answer when a kid asks you “What’s a share?“.
The benefits of owning shares is that they can make your investment grow by capital appreciation, dividends, or a combination of both.
Awesome!
However, there are some risks. This is why every investment account and website ever says: “you may lose money”.
A company can go bust. It first goes “into administration” to be saved by administrators. If it can’t be saved, it goes into insolvent liquidation. If it goes into liquidation, all the stuff a company owns is sold off to pay creditors and investors. Shareholders are the last people to get paid; so there might not be any money left to pay them.
The share price can also go down because either the company is doing badly, all the other companies in the market are doing well, or just because hype has died out. If you sell a share at a lower price than you bought the share for, obviously you’re losing money.
However, in a successful company, the share will usually increase in value over time. The price will bounce higher and dip lower, but if the company is successful the average price of its shares will increase over a number of years.
Buying individual shares
The problem with buying individual shares is that you’ve got to know which companies are going to be successful.
There are ways to value companies that help, but none of them are perfect. You can’t ever be 100% successful. What if your superstar-moneymaker share turns out to be the next ENRON?
You can’t know for sure, so the best plan is diversification: owning a selection of shares (and other investments!) of different types. On a well-diversified portfolio, you should see an average net increase in your investments. More companies should make money than companies lose money.
There’s more to that, but that’s a whole other post…
So: what is a share and why do I want one?
Shares a bits of companies and owning them means that a whole company now exists to make you money.
Owning shares really is passive income – and if I want to achieve FIRE, it’s definitely something I could do with on my side!
