how stocks and shares work

How Stocks and Shares work

Stocks and shares are synonyms and mean that you are buying a small piece of a company. Imagine that you buy a £10 pizza with your friend. You both pay £5 and then each of you eats half of the pizza. This is how stocks and shares work.

We all have that special friend who may eat most of the pizza and leave you with just one piece. Rest assured when it comes to stock no one can touch your slices.

What is the purpose of stocks, why do they exist

Shares have a very long history. Think about it, we share stuff with other people all the time. If you live with housemates you all contribute to the rent or some kind of expense such as Netflix or Amazon prime membership. If you buy a house with your partner both of you will be chipping in towards the mortgage and the bills.

Stocks are pretty similar. They started back in the day to share the prosperity of a company with other people.

You may want to start a business with a friend if both of you think that it will work. When you go to register it each of you will receive half of the stock. This means that when you start earning money each of you will get half of the profits.

Imagine that the company gets big. Then your friends may come to you and say ‘Hey, I want to buy some shares of your company’. Or you may decide to sell some to an investor if you need more capital. Once the company gets big enough you can list it on the London Stock Exchange and I will be able to buy some too.

So what am I buying when I buy a stock

Let’s move on from your business and look at what happens with a big company. A giant firm can have millions of shareholders. If we go back to the pizza analogy, think about a giant pizza sliced in millions of small bits.

Apple for example is worth almost two trillion dollars so it’s not realistic for normal folk like us to buy half of the pizza. Their management team knows that so they have sliced the company in 17 billion little pieces each worth $113.

How stocks and shares work: they make money

When you buy a share, you are buying into the future of a company with the expectation that you will get some money out of it. There is no other reason for the purchase.

I may like or dislike a company but I’ll still buy shares if I think that I’ll make money. It is very important to know that you are not buying the history of the company or its present profits. You are buying the future profits and the stuff that the company owns now. This may be buildings, patents, airplanes, land or something else.

You will earn money from two things: share price increase and dividends. If you buy a share today and the company continues to grow the pizza will get bigger so each of the small bits will get bigger too. Consequently, others will be happy to pay more for your slice when you decide to sell it.

In the mean time the firm would have made a profit. As you are a partial owner of the company the management team may decide to pay you some of the profit in the form of a dividend. It is not a life changing amount of money but it adds up over time.

Just bear in mind that some companies do not pay dividends. This happens because the managers may decide to invest the money in the firm’s future.

So I own the company but someone else is managing it, how does that work

It was around the beginning of the 20th century when someone came up with the idea that businesses will be more profitable if you separate the owners from the management of the company. This is a long topic with a lot of controversy so I won’t be able to cover it in fullness.

Shareholders

You just need to know that as a shareholder you are on the side of the owners. Therefore, you get some of the profits as described above. You also have voting rights, cool right!

In theory you can appoint managers and choose where the business is headed. In practice you’d find out that there are millions of small shareholders like you and I.

There are also a small number of large ones, usually financial firms like banks, pension funds, insurance companies, etc. A few of the big guys can have majority voting rights, say 51% or over. So you end up not being heard as your vote doesn’t matter.

Managers

I don’t want to be cynical but truth be told managers don’t want shareholders to meddle too much into their affairs. Do you want your landlord to come in every week and tell you to tidy up the house?

The business issue is that managers want to get paid, sometimes quite a bit. You on the other hand may think: Oh, well, I’d rather get some dividends than pay the CEO £5 million, can we not sack him and bring in someone cheaper.

Inevitably this creates a conflict and you have to be aware of it. The best you can do as an individual is to check the company or just buy a fund which owns many different stocks.

Can I lose money on stocks

Yes, unfortunately you can so be careful out there! This is just how stocks and shares work. One of the not so bad things is that you can’t lose more than what you put in. The share price can never go negative, ever.

You have to be careful and make sure that you are buying shares. A lot of the investing apps offer CFDs which can cause large losses!

CFDs are a financial product called a derivative and I’d suggest to avoid them like the plague if you find this article useful. Once you get confident you can try all kinds of products, there is no rush.

On a positive note, there are other investments where you can lose more than your own money. An example is starting your own business. Some people just end up unlucky and lose money on property too, despite being considered fairly safe.

What do I do if I bought a stock and it goes down

Just wait, put your phone down, don’t check it every 5 minutes, go out with friends instead. Leave it alone unless you need the money immediately.

If you are going to invest in shares you’ll have to accept the fact that share prices fluctuate. You also have to accept the fact that some of your investments will lose money. It’s just how it works.

When I wrote about the pizza getting bigger, you may have thought What happens if the pizza gets smaller?. That’s when the share price goes down and your investment starts to lose money.

There are 4 scenarios if you find yourself in that situation:

  • The company goes bankrupt and you lose your money. Think of Thomas Cook.
  • The share price never recovers and the company does not pay dividends. If it’s not a lot of money and there is no cost associated with holding the shares I’d probably leave them and wait. No one knows what may happen in 20 years. If you have to sell them it’s a loss.
  • The share price never recovers but the company pays dividends. Considering no costs as above you can keep the shares and try to recoup the loss from dividends. It will take a very long period of time to achieve this. If the dividend is 3% it will take you just shy of 10 years to recover a loss of 20%.
  • The share price recovers over time. Obviously, this is the best scenario. You have to decide if you want to keep the stock or sell it and move on.

You can see that patience is a virtue in investing. Three of the scenarios involve a lot of waiting.

What do I do if there is a market crash

Same as above. Unfortunately financial markets are cyclical. There is a period of prosperity, then a crash, then the whole process repeats itself. In most cases all you have to do is wait. It’s all part of the process, that’s how stocks and shares work.

If you are a beginner you may decide to invest in a fund which holds multiple stocks. This eliminates the risk of a company going bankrupt as the fund owns hundreds of them. Nevertheless, the losses can add up to 50% during a crash. People panic and start selling which is probably the worst thing to do.

The overall market usually recovers over time. The share price of the top UK companies has not moved much the past 10 years but you would have still made money from the dividends. I wrote a more comprehensive article about the effect of dividends, you can find it here.

The last crash was caused by the coronavirus. The US stock market is almost at pre-covid levels. However, UK shares have not performed as well so we’ll see what the future holds. On average a recovery takes between 1 and 3 years. You can see it’s all about patience again.

Conclusion

I am pleased to say that now you know how stocks work. Welcome to the beginning of your investment journey! I’m sure it will be an interesting and rewarding experience.

If you enjoyed this article I would urge you to learn a bit more about the market, stocks and investment funds before you buy anything. Make sure you familiarise yourself with basic financial metrics and the fees charged by funds and brokers. If you don’t feel confident about something just don’t do it.

Never rush to invest, you can always do it at your own pace. Don’t listen to people who tell you that you are missing the opportunity of a lifetime. Tomorrow is another day and the market presents us with new opportunities. There is always some trade waiting behind the corner so you never really miss out on anything. That’s the beauty of it!