August 30, 2014

Why invest in shares?

We hear about them everyday, we are often intrigued by them, but often as newcomers to investments, we have little knowledge of why we should really consider investing in shares. This ultimate FAQ provided by aims to help newcomers to the world of shares (also referred to as equities) become better acquainted with the potential benefits of them.

What is a share or equity?

A share simply entitles you to the profits made by a company (usually a PLC). There are PLC’s which vary in size from small businesses who have listed on the Alternative Investment Market (AIM) to those on the FTSE 100 which is a collection of the biggest British firms. Quite simply, if you own a share in a company then you are a shareholder and as such entitled to some of their profits.

How do I make money from investing in shares?

1) Each financial year, a company will decide how much of its profits it will retain to assist the business in the future and how much it will pay out to shareholders. The payout to shareholders is known as a dividend and is usually distributed on an amount per share basis. So this dividend which is paid out, will usually allow you to have a continued stream of income from the shares.

2) Profits from shares can also be made if the share price simply increases and you capitalise on this. For example, consider you originally bought shares in a company for 500p and the price has now risen to 800p, if you sell your shares you will clearly profit.

Why do companies pay dividends?

Companies are not typically under any obligation to actually pay dividends but it usually is common practice and acts as an incentive for investors. For example, companies are aware that many investors could just as easily invest their money in a savings account and accrue interest without little risk. Therefore, the lure of dividends adds a stronger case to invest in shares for a company.

Dividends are usually paid out following the half year and full year results and as explained above will vary depending on how much of the profits a business needs to retain. For example, if the business has spotted the need for large scale investment in new systems to drive growth, then it may retain more of its profit and pay out less in dividends. Sometimes companies operating a ‘progressive dividend policy’ in which they increase the distribution of dividends as a percentage of profit.

Why do share prices rise and fall?

Share prices rise and fall because of the supply and demand principle. Consider a company has reported exceptionally high profits that has took the markets by surprise, then usually more people will want to invest in this company and the share price will correspondingly rise. Likewise, if a company looks to be in ‘trouble’ or their results aren’t as good as expected, then demand for these shares will fall and the respective share price will also fall.

A number of factors can affect the share price of the company including: their financial results (freely available via investor relations sections online), changes in legislation, and new information detrimental to the company comes to light. For example, News Corporation shares briefly lost a great deal of value when information concerning News of The World’s ‘phone hacking’ allegations came into the public spotlight.

However, one of the biggest factors contributing to a pure rise in share price is a bid from a rival company or even speculation of a bid. Intentions of a bid usually result in share prices rising because demand has surged as the bidding company will have to buyout existing shareholders of the new company in order to take it over.

What are the benefits of shares in relation to inflation?

Shares usually exceed the rate of inflation because companies usually absorb and respond to any inflation when producing products or services. For example, consider the notion that inflation has caused increases in the price of cotton. Clothing manufacturers will then charge more for its clothing products to deal with this rising cost in pursuit of profit. Healthy businesses will usually achieve profits in line with inflation.

How can I invest in shares?

There are a number of ways you can invest in shares, for example through an Independent Financial Adviser or through an execution only broker (whereby you make your own decision on what shares to buy). An execution only broker will normally allow you to open up a share account, or even use your yearly ISA allowance to invest in shares and enjoy the associated tax benefits.

Some theorists suggest that to minimize risk, it is wise to invest in a number of different shares. The logic behind this is that you are limiting the risk of over reliance of one share performing, and if one share falls, the other may counter it with a rise. This concept also provides a pull for investors who opt to invest in funds, which are essentially multiple holdings in a variety of companies.

Prior to investing in shares, you should always understand that the value of investments can fall as well as rise. Investments can be very volatile and it is common practice to appreciate that they are designed for the medium to long-term outlook (minimum 5 years, average of 10 years).