Friday Finance: what even are shares?

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This is an extract from The Poor Man’s Guide to Financial Freedom: A Realistic, 10-Step Manual for Building Liberating Wealth on a Low to Medium Income.

Executive summary

Jargon: Shares can also be called ‘stocks’ or ‘equities’.  Together with bonds, they can be called ‘securities’ because they can be sold on to third parties.  Purchasing shares means to own a part-share of a company, as opposed to lending a company money as with bonds.  If you bought 100% of all Toyota shares, you would own Toyota.  I expect that my readers will only own tiny little slivers of many different companies.

Risk: high.  You could lose money, especially in the short term.  For the record, let’s look at the historical worst-case scenario (which might yet be beaten): if you invested $1,000 at the worst moment possible, in April 1929, your investment would have plunged to about $352 by October, 1932.  Including reinvested dividends, it would have taken more than 7 years to get your full $1,000 back.[i]  The worst day ever was the ‘Black Monday’ event of 1987 in which the stock market lost 22% of its value in one day!  On the other hand, the stock market rose by about 33% over 1995.  Shares are the roller coaster of investments.

Return: potentially high.  To nominate an average return is a tricky issue because it’s easy to manipulate the data depending on which index you use, together with the start and end dates.  The average returns for the years 1932-2006 are going to be way better than those for 1929-2009 because the first set of data conveniently skips the the Great Depression that began in 1929 and the Great Recession that began in 2007.

According to Investopedia, the S&P 500 averaged about 8% per annum from 1957-2018.[ii]  I reckon this figure is as good as any: the S&P 500 is the biggest index, 1957 was the year it began following 500 stocks, it is fairly modern and the period contains some representative downturns.

Inflation-adjusted, 90-year chart of S&P 500 Source: https://www.macrotrends.net/2324/sp-500-historical-chart-data. I highly recommend following the link and playing around with this chart; you’ll learn more than I could ever teach you about the vagaries of the market.

Some might argue that Investopedia’s selected period is biased as it skips the 2020 crash that is occurring as we go to print, but such events are too recent to have been properly incorporated.

I also like that this is one of the lower calculations of average stock market returns.  One should always keep expectations conservative.  In fact, for the purposes of this book, let’s assume stock market returns of just six or seven percent over the long run. 

Keep in mind that stock market returns are wildly volatile, even over rolling 20-year periods.  In addition, past performance is no guarantee of future performance.  Just because we got 8% returns over the last 60-odd years does not mean that we’ll get the same outcome over the next 60 years.  We might get 12%, instead.  Or 5%.  Who knows.

You must understand that the value of your shares may plummet at any moment, in a way that cash and bonds will not.  Shares carry with them a high level of risk.

There is a simple way of managing this risk: time.  If you invest in shares for only one year, there is a very high chance that a stock market downturn will mean that you suffer a loss.  Over five years, it is still pretty risky.  Once you get up to ten years you will probably be okay because that ought to be enough time to recover from any downturns.  However, keep in mind that the worst ever ten-year period was 1928-1938, when the stock market lost an average of 1.3% per year.  That’s what a Great Depression will do to you.  But cheer up – the best ever ten-year period was 1918-1928, when the market rose an average of almost 20% per year.

How long is long enough?  The best, and most annoying, answer is: the longer the better.  Ten years is the bare minimum.  Fifteen years is good, but not as good as twenty years.  If you lived long enough, two hundred years would be fantastic.  If they ever invent life-extension technologies, we’re all going to be rich.

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Payday!

You should be investing in shares for as long as possible in order to deal with the inevitable downturns.  If you are in your twenties and investing for your retirement, shares could be a good place to put your money.  If you are saving up for this year’s Christmas presents, put your money somewhere else.

The details

Shares, not bonds, are the exciting, high-octane asset class.  They are the movie hero dodging bullets and jumping from planes.  Shares often get into terrible scrapes, like getting tied down with a laser moving towards them, but they usually triumph in the end.  Or at least survive.  To see why, we must first learn what they are.

There are two types of company: a private company and a public company.  It is the latter that you can invest in on the stock market by buying shares in that company.  To understand one, you must understand both.

An example of a well-known private company is PricewaterhouseCoopers.  Ordinary people like us can’t buy shares in the company on a stock market.  It’s kind of like an exclusive nightclub.  To get into Club PricewaterhouseCoopers, you may need to get your name on the door, that is, to be an institutional or high net worth investor.  If you turn up with your $5,000 trying to invest, the burly bouncer will look you up and down, and sneer, “Not with those shoes, bro.”

This is called ‘private equity’, and your exclusion is no big problem.  When we come back to it later, I’ll tell you to give it a miss anyway.

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Too obscure?

An example of a public company is Apple.  It’s more like a Starbucks café – anyone can stroll in any time, regardless of who you are or how little you have to invest.  Even if you’re not wearing a tuxedo and monocle, you can easily purchase shares in Apple.  Press a few buttons online and it’s done.  The vast majority of big companies you already know are publicly listed companies.

If a private company or business goes bankrupt, the owners must use their own resources to pay back creditors.  They might lose their house.  On the other hand, a public company has ‘limited liability’, which means that shareholders only lose the money they have invested in it, nothing more.  If you invest $10,000 in Acme shares and it goes bust, you only lose your $10,000.  You don’t also have to sell your house or other possessions in order to pay back any remaining debts the defunct company may owe.   This is why such companies can have ‘Ltd.’ after their names, in some countries.  It tells everyone what kind of company it is and what they can expect in the case of a bankruptcy.

Further confusing matters, some countries also allow a form of limited liability private company that is not listed on the stock market.

A publicly listed company – one that has its shares available for trading on the stock market – is subject to additional regulation.  The specifics depend on the jurisdiction, but this may mean additional reporting requirements (i.e. of profits, liabilities, number of women or minorities hired etc.) or the company may be restricted in how much its CEO can be paid. 

Public companies are usually required to hold annual shareholder meetings where any stockholder can attend and ask questions, though in some countries the rules have been changed to increase the amount of stock you must own to gain entrance as some activist shareholders were buying a very small number of shares just to go along and ask pointed questions about environment standards, union rights and that kind of thing.

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Walmart 2019 Shareholders’ meeting

Companies often start out private but later ‘go public’ when they need capital to grow.  Being private and having just a few investors is suitable for the start-up phase, but once companies need a lot of money to expand, selling public shares is a common way to raise cash.

Are you scratching your head yet?  Before we go any further, I remind the reader of something mentioned earlier: actually investing in shares and bonds is incredibly easy.  I will show you how soon.  Don’t worry yourself about that while you’re getting confused over the following convoluted details.  This is mostly background information so you can understand what’s happening under the hood. 

Quick recap: shares are the riskiest and potentially most rewarding mainstream form of investment, alongside real estate.  A share is where you buy a part, or ‘share’, of a company; that is, you actually become a part owner.  Though it may be only a tiny little microscopic part. 

There are basically two ways you can make money from shares, (a) when the company pays out a dividend to stockholders or (b) if the share price rises.

(a) Dividends

A public company’s main purpose is to generate a return for its shareholders.  Sometimes they do this by paying out a dividend.  This usually means that they have generated good earnings and are sharing the spoils with their investors.  Some companies regularly pay out dividends – mostly large, well-established companies whose shares are called ‘blue-chip’ stocks.  Examples include IBM, Coca-Cola and, erm, Boeing.  The term comes from high-value casino chips and its first recorded use, would you believe, was during the inauspicious year of 1929.

If a company is struggling, it might reduce dividends or not pay them out at all.  Conversely, there are cases where a company will make dividend payments that are higher than its actual profits in order to keep shareholders happy.

(b) Share Price

A company’s share price might rise because there has been an increase in earnings per share and thus an increase in underlying value.  The share price might also rise if investors think that its prospects for future growth and returns have improved.  For example, imagine that Acme Inc. is a startup with a bold new design for cheaper, more reliable widgets.  It floats on the stock exchange, and the share price is modest because no one knows for sure whether this idea will work or not. 

Fast forward ten years, AcmeWidge™ technology dominates the market for widgets and all its competitors are struggling to catch up.  Now that Acme Inc. is generating strong yearly profits, the share price will be much higher than it was before.  Those people who took a risk on it in the early years and bought cheap shares will have been rewarded with a very strong return on their investment.  When they sell their shares, they will make a sizeable profit.  However, the company might equally have failed if the technology had not worked and its share price may have fallen to zero.

A company might also increase its share price by using its profits to conduct a ‘share buy-back’ – as the name suggests, it buys back its own shares.  If there are fewer shares on the market, then each share remaining is worth more.  As with dividends, it is possible for a company to buy back shares to a value greater than its actual profits.

You can only profit from an increase in the share price if you actually sell the shares once they are more valuable than when you bought them.  If the share price starts at $0.43 each, then goes up to $4.89, then falls back to $0.22, you only made profit if you sold them when they were high.  If you held on to them after they fell back down lower than they started, you end up with a loss.  The earlier profit was only a ‘paper’ profit, not a ‘realized’ profit – on paper you had the money, but you never really had the money because you didn’t sell.  Nevertheless, this book will soon explain that holding shares for the long term is a better strategy than trying to quickly sell them as soon as the price jumps.

Not all profits go straight to shareholders in the form of dividends or share buybacks.  The company might also invest in new equipment or research and development.  Google dedicates about 13% of revenue to such research, much of it top secret.  This can help the long-term competitiveness of the business, which in turn can help the share price rise in expectation of strong future growth.

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In summary, you can make money from shares if they pay a dividend or if the share price rises, but you can also suffer a loss if the share price falls and you have to sell at that lower price.  Some companies fail completely, like Enron, in which case the value of your investment in that company falls to $0.00 and you never see your money again.

A bond is a loan, so the company is supposed to pay you back the agreed amount.  If the company goes bankrupt, you are fairly high on the list of creditors so you might get some of your money back.  Shareholders, on the other hand, are considered part-owners of the company and are therefore dead last on the list of people to get paid back in the event that it goes belly-up.  You aren’t owed money – you part-own the entity that owes money!  This is what makes it the riskiest investment.  However, as stated, a publicly listed company has limited liability.  You can only lose the money that you invested, no more, even if the bankrupt company still has unpaid creditors after liquidation.

Few are rash enough to put all their money into a single stock.  Generally, people invest in a variety of shares.  Once you have over a dozen, the chances of them all going broke is pretty low. 

A more common cause of losses is when the share market generally declines in value.  That is, when the stock price of pretty much every company goes down at the same time.  This happens fairly regularly, and the last big fall (at the time of writing) was the Great Recession of 2008.

There are times when pretty much all shares are rising in price, regardless of how well individual companies are doing.  This is called a ‘bull run’, and yes, that’s why there’s a statue of a bull near the New York Stock Exchange.  Imagine a bull charging ahead regardless of everything going on around it – that’s what the market sometimes does.

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On the other hand, sometimes the market goes down dramatically, or sideways, or all over the place.  At these times, poorly managed companies are likely to go bankrupt, and even good ones might be in danger.  This is called a ‘bear market’.  Imagine a bear raging around, clawing everything it passes.  That’s how it is.

An investor who is ‘bullish’ is not one who is stubborn or prone to telling tall tales.  It is one who thinks everything is going great and now is a perfect time to invest.  An investor who is ‘bearish’ is not one who is unusually large and hirsute.  It is an investor who thinks now is a terrible time to invest and that you should move to safer investments.

You should not be bullish or bearish.  By the end of this chapter, you will understand why.

Markets tend to go in cycles between bull and bear markets, with the bull runs generally more than making up for the bears in the long run.  Some say the cycles average eight years, but it is totally random.  If you are thinking of investing during the bull runs and getting out during the bear markets, I’ve got a whole section entitled ‘Timing the Market’ which will explain why you should not attempt to do that.


[i] https://www.nytimes.com/2009/04/26/your-money/stocks-and-bonds/26stra.html

[ii] https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp 

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