Why invest in shares?

Whether its retiring early, saving for the childrens’ education or paying off the mortgage, everyone has dreams they can achieve by saving.

What are shares?

There are a number of different shares you can buy, including preference shares, bonds, and gilts but the most popular type is the ordinary share. Ordinary shares simply represent ownership of a company.

So, when you buy shares, also known as equities or stocks, you literally become a part-owner of that business. If, for example, a ABC Plc has 100,000 shares worth £1 each and you buy £1,000 of shares, you own 1% of the company.

Companies do not have to list on the stock market to issue shares. Many businesses start life with friends and family as shareholders. These businesses are called unlisted firms and their shares are often referred to as ‘unquoted’.

There are more than 2300 shares listed on the main UK market and 700 on AIM, from big household names such as Marks & Spencer and Tesco to smaller businesses such as Eidos, the technology company.

As a shareholder you have a say in the company’s affairs by voting at company meetings and, of course, the ability to share in its fortunes. If the company does well, the value of your investment should rise but if it does badly, you could see your shares fall in value.


What are the benefits of share ownership?

There are two ways you can benefit from owning shares. The first way is through the growth of the company. Say, for example, ABC Plc earns revenue of £100,000 in one year. After deducting its costs, it has £50,000 left – its profit.

It then reinvests this money in the business, perhaps by investing in better technology, which enables it to cut costs and, therefore, make a bigger profit the following year. If it can continue to improve its profits, demand for its shares will grow and the share price will rise. This type of company, known as a growth stock, is popular with investors who do not need income from their investments.

Many companies also pay a dividend. Say, for example, XYZ Plc earns revenue of £100,000. After deducting its costs and reinvesting in the business it has £10,000 left over. It decides to return this money to shareholders by paying a dividend. If the company has 100,000 shareholders, each share will get a dividend of 10p per share. So, if you own 100 shares, your total dividend will be £10.

Shares that pay dividends are generally known as ‘Income’ stocks. Companies can return money to shareholders in other ways too such as buying back their shares. This increases the value of those shares still in circulation.

By investing in shares you are also linking your financial wealth to the health of the UK and overseas economies. The proportion of goods and services sold in the UK and abroad typically rises when economies are growing and falls when in recession, thus affecting profits.

The fact economies spend longer in a growth period than in recession has helped shares produce better returns than other assets and, crucially, beat the effects of inflation. If you left £10,000 under your mattress, for example, it would be worth just £9,750 a year later, assuming inflation had increased the cost of goods and services by 2.5% that year. After five years it would have fallen to just £8,810.

Savings accounts do little to protect your money from inflation as your real rate of return is small, averaging 1.8% a year after inflation according to Credit Suisse First Boston’s Equity Gilt Study 2003. Shares, on the other hand, do have the ability to produce better gains, averaging 6.8% a year after inflation.

But, as investors who had money in the stock market between 2000 and 2003 will testify, share ownership is not without its risks.


The risks of investing

Inflation may eat away at your savings over the long term but if share prices fall, you run the risk of losing money. If a company you invest in goes bankrupt, your shares could become worthless.

But companies do not have to go under for you to lose money. Other investors may simply decide that the company is not worth as much as when you paid for it, perhaps because it is losing market share, and if enough of them think that, your investment will fall in value. Shares also tend to fall when the economy is deteriorating as investors recognise profits will be lower.

These are not, however, reasons for you to stay out of the stock market. But they should help you recognise the importance of building a broad portfolio with shares in different companies, industries and, even, countries. A good way for a beginner to do this is to invest in a fund, which spreads your money across 50-100 companies.

It is also worth noting that apart from those companies that go bust, shares that have fallen in value can recover in time. Sometimes if a share has fallen in value it can be worth holding on until it recovers but at other times it may be better to cut your losses and invest in a company that has better prospects. The option you choose will depend on the company you are invested in and your individual circumstances.