What are shares and why buy them? This article will explain why people buy shares instead of just keeping your money in a savings account with a bank.
Welcome to Simply Economics. This article is the second in a series that is perfect for readers who have a good economic background and are looking to apply their knowledge in the real world. Click here to find out more about the series.
What are shares and why BUY THEM?
Shares are part of a company that investors can buy. Shares are very useful to companies as selling shares allows the company to raise capital (cash) which they can use to grow the business in order to grow profits.
Furthermore, shares allow investors to control risk in their investments as they can buy parts of a business and can make profit off the share as the business grows instead of running or buying their own business.
This means an investor has minimal liability for the actions of those who run the business and do not need to do the business themselves. Instead, if the directors of the business grow the business then the shareholder (investor) can make a profit.
The maximum loss an investor can make is the amount of money they invested in the company.
WHY BUY SHAREs?
REAL RETURNS COMPARISON
Real returns are returns adjusted with inflation taken into account for.
As shown by the bar chart below if you were to invest in the UK equities 50 years ago you would have made 5.6% a year after inflation which is much more than the 1.4% per annum you would have earned if you held cash for the past 50 years.
However, it is not as simple as it seems. This is because the time period taken into consideration is important:
- For short-term requirements (such as paying bills, etc), it is best to hold cash.
- For mid-term requirements (5-10 years), it is best to hold government bonds. This is because you know how much return you will get on them (the stock market can be volatile in the mid-term).
- For long-term investments (10 years+), it is best to invest in shares as they give the highest returns over long periods. However, it is imperative that you invest new capital regularly to maximise returns.
HOW DO SHARES MAKE YOU MONEY?
The best way to explain how money is made through investing in shares is by giving an example:
A company needs to raise funds in order to have capital (cash) to grow the business so they can make more profit.
There are many ways to raise these funds: take a loan, selling fixed income securities or issuing shares.
If the company decides to issue shares, it means the company is dividing their company smaller ‘pieces’ known as shares. The value of 1 share depends on:
- How many pieces the company is split into
- The value of the company.
So, if a company with an assets value of £100,000 splits into 100,000 shares, 1 share is worth £1. Let us say you decide to buy 100 shares for £100.
If the directors of the company do good business throughout the year and the profit at the end of the year is £100,000 it would cause the value to go up to £200,000 – profits + assets value.
This would mean the value of 1 share has gone from £1 to £2 which means the value of your shares has gone from £100 to £200.
From here, you can buy more shares, hold what you have, or sell the shares to another person. If you decide to sell the shares you would have made £100
Companies share the profit made to shareholders. This is known as dividends. It is recommended that an investor should re-invest these dividends into the same company as returns with dividends invested are much less volatile and higher than returns if dividends are not re-invested.
In conclusion, shares are parts of a company that are sold to investors so that the company can raise funds to grow the company. The way you can make money from shares is buying them at a low price and selling them at a higher price. Alternatively, you can hold onto the share and make money off the shared profit known as dividends.
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