Stocks, shares, equities... three very familiar words, even to those of us who’ve never considered investing. But what do they actually mean – and is there a difference between them?
What’s in a name?
- Stock is the word used to describe the certificate which investors are given when they invest in a company, called a ‘stock certificate’.
- Shares refer to the individual units of a public limited company’s share capital that are traded on the stock exchange.
- Equity means the collective value of the ownership interest that shareholders have in a public limited company. This is similar to the ‘equity’ you have in your own home – that is, how much its market value might be worth after all debts have been taken into account.
Now the good news. It isn’t important that you understand the details behind these terms, as they are all used interchangeably to describe the exactly same thing; owning a part of a public limited company either directly or via an investment fund.
Where do the returns and losses come from?
The return and losses from shares comes from two potential sources:
- The change in the capital value of a shareholding
- The dividends, if any, that are paid
Each share in a public limited company has a nominal capital value, which is the total initial value of the equity in the company (and any additional capital raised through the issue of new shares) divided by the number of shares issued.
However, what’s more important to you, as an investor, is how much you paid for your shares and what they would be worth if you sold them today. This is the capital value of your investment and fluctuates on a daily basis depending upon the outlook for that particular company. This, in turn, depends on a huge range of factors including:
- How well that company’s products and services are selling
- How much it costs to produce those products and services; and
- What the outlook is like.
A wide range of external economic and political factors such as interest rates, inflation, exchange rates and international trade agreements also influences a company’s prospects and profits.
Given that all of these factors, and more, can affect a company’s profits and future prospects, it isn’t hard to see why their value can change by quite a large amount in a single day or even a single hour.
Volatility: the reason why more people don’t invest
This volatility and potential for loss is the single biggest factor that puts people off this type of investment. If you’re investing in shares, you need to consider them a long-term investment, which means owning them for five years or longer. Over the long-term, daily fluctuations in the value of shares becomes less visible when considering the whole market, although historic daily changes in value remain more visible in individual shares.
It shouldn’t be too difficult to keep track of your investments’ progress. The value of shares in individual companies is widely available in real time on the internet and end-of-day prices are published in the following day’s newspapers.
The collective capital value of shares in a ‘basket’ of companies is shown as an index. The ones people are most familiar with are the FTSE indices such as:
- The FTSE 100 – this shows the capital value of all the shares of the 100 largest companies traded on the London stock exchange.
- The FTSE 250 represents the capital value of the shares of the 101st largest company to the 350th largest company traded on the London stock exchange.
- The FTSE All Share index doesn’t cover all the shares traded on the London stock exchange, but it does represent the majority of the capital value (98-99%) of the shares traded in London.
When you see these indices published, it is usually just the capital value of the shares that you are seeing, and not the total return including dividends.
The importance of dividends
Dividends are the way in which companies distribute some of their profits to shareholders. They also usually keep some profits for other purposes, such as investing in research and development, buying more equipment or paying off debts.
Because the capital value of shares is available 24/7, this is what people tend to think about when considering the value of shares. However, historically, dividends have been the most important component of the overall return, as this example from the Barclays Equity Gilt Study 2016 illustrates:
The effect of dividends: an example
If £100 was invested in UK shares at the end of 1945, what would be the real (today’s money) value at end of 2015?
Looking at it another way, by reinvesting dividends, the annualised real rate of return increased from 1.3% p.a. (the return on the capital value only) to 5.8% (the total return including dividends reinvested).
By comparison, gilts (loans to the UK government) would have generated a real return of £220 and cash deposits of just £177 over the same period. (Source: Barclays Equity Gilt Study 2016 figures 14 and 15)
Dividends are also much less volatile than capital values, but that doesn’t mean dividends always rise. During difficult economic times, some companies may not make a profit and may have to cut their dividend or stop it altogether.
Between 1997 and 2001, dividend income from UK companies fell by a cumulative 15% (Source: Barclays Equity Gilt Study 2016, page 62).
Understanding that dividends can fall is important, particularly if you plan to live off dividend income in retirement. So, build in a safety margin, just in case.
The current dividend yield (as at 30 December 2016) across all the companies included in the FTSE All Share Index is 3.47%.
Which companies might pay higher dividends?
Some companies – usually the older well-established ones – aim to pay high and increasing dividends. These companies find it more difficult to grow as they usually already have a high market share and established competitors. Therefore, the focus of these businesses is to run themselves more efficiently, and deliver higher profits by cutting costs. Investors who buy shares in this sort of company are looking for stable income rather than fast growth in the share price.
Younger or fast-growing companies tend to pay lower or no dividends as they are ploughing their profits (if they make any) back into the business. Investors who buy shares in this sort of company are taking a gamble that the company’s business plans will pay off and eventually deliver high profits, which in turn will increase the share price.
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