previous
next

Understanding
shares

This chapter is designed to offer a basic understanding of shares.

Speak to a financial adviser who will be able to offer further advice about investing in shares and whether they are a suitable investment for your needs.

What are shares?

By buying a share in a company you are, for better or worse, tying the fate of your investment to the performance of that company. You are buying a part of that company and its future profits, or if the company doesn’t perform well, a share of its losses. You may receive a share of the company’s profit in the form of a dividend payment – you can also benefit from a future rise in the company’s share price. However, the value of investments in shares (also referred to as ‘equities’) can go down as well as up.

Investing in shares may be more suited to someone willing to accept medium or higher risk, as they are generally regarded as riskier than some other investment vehicles such as government or corporate bonds.

Historically, the best returns for long-term investors have been from shares, although past performance should not be assumed to be a guide to future performance.

Stock markets can be divided into two separate categories – primary and secondary. Both are equally important to companies wishing to raise capital.

The primary market

This consists of shares in two types of companies.

  • Those issuing shares for the first time (an Initial Public Offering or IPO).
  • Those that are already public and are looking to raise new funds by offering new shares.

The secondary market

Existing company shares are traded on a daily basis. Movements in their prices indicate the relative performance of the companies over time. Most investment in shares is in the secondary market.

Investing in shares may be more suited to someone willing to accept medium or higher risk, as they are generally regarded as riskier than some other investment vehicles.

The share price

Share prices in the secondary market reflect the supply and demand for the individual share.

If more investors wish to purchase than to sell a particular share, the share price rises.

If more investors wish to sell than to purchase a particular share, the share price falls.

Many factors will influence the value that investors place on a share. The dominant factors affecting the demand for shares can be broadly categorised as follows:

Macro factors

  • Political events
  • Legislative changes
  • Unexpected events (terrorism/natural disasters)
  • Interest rate movements
  • Inflation forecasts

Micro factors

  • Company’s profit forecasts/warnings
  • Company’s dividend history/policy
  • Merger and acquisition activity
  • Changes in management
  • Activity in competition
  • Valuation of shares

As well as these ‘rational’ factors, more emotional factors may affect a share price. For example, the development of a ‘herd mentality’ with investors buying a share because of a perception that others are doing the same.

Share classification

Shares are classified in accordance with the nature of the issuing company. Typically shares are classified in the following way:

Sector

Sectors relate to the key operations of the company, i.e. the product it sells or the service it provides, for example, pharmaceuticals, telecommunications, and retail sectors.

Size

Defined as small, medium and large capitalisation. For example, a ‘large cap’ would be a large multi-national company such as Microsoft.

The characteristics of the company

Shares can be categorised in accordance with the current and future earnings or dividend characteristics of the company:

  • Growth shares are shares in companies that have experienced sustained growth in sales and earnings, with a consensus that this is likely to continue.
  • Income shares are shares in companies which, unlike growth shares, have dividend policies which favour paying out a large proportion of the profits to shareholders.
  • Value shares are shares in companies which are attractively valued relative to the shares in other companies in their sector. This means the investor believes the share price is below what the actual asset is worth, even if that asset does not seem attractive at that point in time.

How they fit with the economic cycle

Shares in cyclical sectors usually rise when the economy is growing and fall when the economy is slowing down, for example building, general retailers, and leisure sectors.

Shares in non-cyclical sectors attract a constant level of demand which means they can obtain a more constant value in a recession, for example pharmaceuticals, utilities, and food retailers.

and finally...

The stock market may have the potential to deliver higher returns than other investments, such as savings in a bank or bonds. However, there is significantly more risk involved, with more knowledge required to make the right decisions.

Which shares you select depends on your attitude towards risk. Nobody can predict the stock market and therefore it is wise to choose a diversified portfolio of shares in different companies across different sectors.

A convenient way to gain exposure to stocks and shares whilst diversifying risk, is to invest in a fund holding a collection of shares.

This chapter has been designed to give a basic understanding of investing in shares. It is not designed as investment advice. The value of shares may fall as well as rise. Past performance is not a guide to the future.

The golden
investment rules

Investing in shares involves risk taking. There are a number of golden investment rules to help reduce an investor’s overall exposure to risk:

Spread the risk

Between different companies and different sectors – diversification is key!

Keep up-to-date

There are a number of sources available online for checking share prices; you can see the price changes to the minute as well as the high and low prices over defined periods.

Stay calm

The stock market often reacts in an exaggerated manner and can move sharply from day-to-day. Generally, the aim is to ‘buy low and sell high’. Sounds easy, but it can be much more difficult in reality.

Reduce the losses

Should you face the scenario where a share is not performing as hoped, you may wish to consider cutting your losses. It is important to consider pre-determining when to sell shares – the lowest price where you feel you cannot afford to lose more. This strategy should also be used to determine the highest price at which shares will be sold – it’s important not to be too greedy as stock markets can be volatile, meaning positive returns can quickly disappear.