Mention investing to most people, and the first thing they’ll think of is buying and selling stocks and shares.
But what exactly is a share? Why do companies sell them? And why should you even consider buying them?
To answer this question, let’s go back to the adventures of 16th century explorers and traders, and see how the stock market came about.
(By the way, in case you’re wondering, the words ‘stocks’ and ‘shares’ are used interchangeably. In practical terms, there’s no difference between the two).
Exploration, trade routes and treasure: all very risky
The first public companies – companies with freely tradeable shares – were created in the 16th century. Up until then, most companies had been privately owned by small groups of individuals. So what changed?
At the time, European explorers were navigating the world, looking for trade routes and treasure. Such voyages were very risky: the ships could be lost, or the crew killed, in any number of ways.
So funding these voyages was difficult. You would make a fortune if the voyage succeeded. But there was also a high chance of losing all your money. So very few people had sufficient wealth on their own to take the risk involved.
However, by dividing the company into equal shares, the risk could be spread across many owners. Rather than staking all your wealth on a single risky voyage, you could invest just a small part of your savings.
This meant investment was open to a wider range of people, which in turn meant that more voyages could be financed. And with more ventures to choose from, investors could also diversify their risk – investing in several expeditions rather than just one.
The spice trade, coffee houses, and the London Stock Exchange
Among the first companies to be set up in this way were the Muscovy Company (which planned to open a trade route between England and Russia) and the better-known Dutch East India Company (first formed to develop the spice trade).
The idea took off, and by the late 1600s, there were more than 100 ‘joint stock’ companies. When investors wanted to trade shares, they’d meet up in coffee houses in the City of London. The system was gradually formalised, and the first regulated stock exchange – the London Stock Exchange – was founded in 1801.
Companies still issue shares for much the same reason – to raise money. They can also borrow from the bank, or from investors, by issuing bonds. We’ll look at these another time.
But the key advantage for a company in selling shares (or equity) in itself is that there is no obligation to repay the money or make interest payments. As owners, shareholders take their chances with the company. If the company goes bust and its assets are sold off, then the banks and bondholders are in front of shareholders in the queue for that money. In practice, if a company goes bust, a shareholder can expect to lose the lot.
Buy shares, and share in a company’s fortunes
This makes owning shares sound very risky. And it is. But as we’ve already discussed, there are ways to reduce that risk, through sensible diversification. And the flipside of the risk being greater is that the potential rewards are higher to compensate.
Also I find something intrinsically very exciting about the whole idea of share ownership. There are all these companies out there, from the smallest biotech to giant multinationals, and you and I have our pick of them.
If we can find a company that we think is doing a good job, and has good prospects, then we can share in its fortunes simply by going online and pressing a few buttons. It’s the closest that many of us will come to setting up our own business.
Of course, making money from it all depends on choosing the right companies at the right price in the first place. We’ll talk more about how you do that in the next email.
What it means to own a share
So let’s just spell out what it means to own a share.
A share is a small piece of a company. It’s that simple. Owning a share means you have a stake in that company. So if you own a BP share, you own a bit of BP.
Once upon a time, when you bought shares, you would be issued with a physical stock certificate. Nowadays, records are generally kept electronically by your broker, which makes shares easier and cheaper to trade.
A company like BP is so vast that it’s hard to get your head around the idea of owning part of it. So what does it mean to own part of a company? Let’s take a simple example.
Say you and nine friends clubbed together to buy a property to rent out. If each of you contributed an equal tenth of the buying price, then you’d each expect to get 10% of any rental income generated. If the house was sold, you’d expect to get 10% of the proceeds. And you’d probably also expect to get a say in appointing a management company to run the place.
It’s the same story with a company. As a BP shareholder, you can attend the annual general meeting (AGM), and vote on issues such as director pay and the appointment of various board members.
But the most important thing – and the real reason you buy shares – is that you are entitled to a share of the profits generated by the company. This is what lies at the heart of valuing a company, and that’s what we’ll start to look at next time.
Follow John on Twitter || Google+ John Stepek
• This article is taken from our beginners’ guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here