When it comes to investing, stocks and shares are arguably the most popular instruments used to build wealth. And for good reason.
Historically, the stock market has dominated other asset classes in terms of wealth-building performance. And thanks to rapid technological innovation, the barriers to entry have been significantly lowered in the last 20 years. So much so that someone with as little as £20 can get started on their investment journey.
With that in mind, what exactly are shares? What sort of returns can they realistically generate? And what are the risks investors are exposing themselves to? Let’s break it down.
What are shares?
Shares represent a small piece of equity within a business. Most investors buying and selling shares on the stock market are strictly investing in public companies rather than private ones. But the latter type does have shares as well.
An investor buying shares in a company is the equivalent of buying a small piece of equity. That makes them an owner. In fact, it’s technically accurate for an individual to buy a single share in Apple (NASDAQ:AAPL) and then call themselves an owner of Apple.
As owners, shareholders have a claim on the profits companies generate. The size of their claim is proportional to the number of shares they own within a business. More shares mean they are entitled to a larger cut of the profits.
This concept is what drives the underlying value of a stock. As an enterprise increases its earnings, the value of each share increases. And in the long run, that translates into a higher stock price.
How do shares in a company work?
Almost every company worldwide has a different number of shares outstanding. Businesses create new stock issues for investors to buy through various mechanisms such as IPOs, secondary offerings, and rights.
Why? To raise money.
Instead of taking on debt, which may be unaffordable, a firm can choose to sell some of its equity on the stock market. This capital can then be reinvested into growth projects, acquisitions, or even financial restructuring in the pursuit of improving the business.
When success has been achieved, and growth starts to slow, many corporations begin redistributing their earnings back to the owners – the shareholders. This can be achieved in various ways, but the two most common include share buybacks and dividends.
This is why growth stocks typically see rapidly rising share prices, while mature businesses tend to be more stable with higher dividend yields.
Average returns of shares
The average return of shares is typically measured by a benchmark index. The FTSE 100 is often the go-to choice in the UK since it contains the largest 100 publicly traded businesses on the London Stock Exchange. Across the pond in the US, the S&P 500 is often the preferred benchmark.
The table below marks out how shares have performed after inflation compared to other asset classes over the last decade.
|FTSE 100 (includes dividends)||S&P 500 (includes dividends)||High-grade corporate bonds||Real estate||Gold|
Even with lower returns than the S&P 500, UK shares, as measured by the FTSE 100, have clearly outperformed other popular asset classes. And while a 6.33% annual return may not seem like much, when compounded over decades, it can translate into significantly superior gains.
|Years compounding||FTSE 100 (includes dividends)||S&P 500 (includes dividends)||High-grade corporate bonds||Real estate||Gold|
Of course, it’s important to highlight that these figures are taken from a single slice in time. Average returns have varied. And while stocks have historically outperformed other asset classes, there have been multiple periods where that wasn’t the case.
2022 serves as a perfect reminder that the stock market doesn’t always go up. Stock market crashes and corrections do happen. And they can be quite brutal for shareholders who don’t prepare, financially and mentally.
However, it should be noted that even after the most horrific disasters, such as the 2008 financial crisis, the stock market has always eventually made a complete recovery before reaching new heights.
Benefits of investing in shares
While investing in stocks and shares isn’t risk-free, numerous benefits can make it a worthwhile endeavour for many individuals.
- Build wealth faster: The return potential of stocks has historically outpaced many alternative options, such as bank deposits, gold, bonds, and real estate.
- Protect from inflation: Inflation adversely affects stock prices in the short term. But in the long run, they have historically outpaced the devaluation of money.
- Earn regular passive income: Many mature businesses aim to provide shareholders with a reliable and consistent stream of growing passive income through dividends.
- High liquidity: Stocks that sell on major stock exchanges, such as the London Stock Exchange and New York Stock Exchange, have high liquidity. This means investors can buy and sell shares almost instantly.
- Diversification: Investors can avoid putting all their eggs in one basket by investing in a broad range of businesses.
- Low barriers to entry: With commission-free trading becoming more widespread, investors can begin their investing journey will only a small amount of starting capital.
Risks of investing in shares
Investing in shares is anything but risk-free. Investors constantly have to balance risk with potential reward. And these scales can be tipped at almost any time. Some of the most significant risks to consider before investing in stock include:
- Volatility: The stock prices of even the world’s best businesses don’t rise in a straight line. Shares are notoriously volatile. And a poorly timed purchase can transform into a terrible investment.
- Expertise: Picking stocks requires some expert knowledge and time investment for research and analysis that not every investor is capable or willing to put in.
- Wealth destruction: A poorly constructed stock portfolio can very easily destroy wealth rather than create it.
What to consider when buying shares
Two of the most overlooked factors when starting an investing journey are trading costs and taxes. Buying and selling shares isn’t free. While the cost has drastically reduced over the years, it isn’t negligible. And investors must carefully consider which type of account is best suited for their financial situation.
As for taxes, both dividends and capital gains are subject to taxation. And while the rates can vary, it’s a cost that most people typically overlook until the last moment.
Fortunately, there are some tactics UK investors can deploy to minimise or even outright eliminate their tax expenses.
- Guide to Tax-Efficient Investing in the UK
- How to Avoid Capital Gains Tax on Shares in the UK
- What are Dividends, and How are They Taxed?
How to buy shares
To buy shares in the UK, investors need to open a share dealing account – these are something referred to as trading or brokerage accounts. These grant access to various segments of the financial markets, including the stock market, where investors can start putting their capital to work.