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Understanding shares, stock exchanges and indices

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What are shares?

Companies have two choices when they want to raise money to grow their business: to borrow from a bank or issue shares. A share is a slice of a company that, technically, means that its owner has a small claim on that business’s earnings and assets. As a shareholder, an individual is one of many owners of that company.

The key advantage in issuing shares (or equity) is that the company doesn’t need to pay back the capital amount or make interest payments. Instead, shareholders – the people who buy those shares – can hope to receive dividends and see a capital gain on their investment.

 

There are two different types of shares:

  • Ordinary shares make up the majority of listed shares. They represent ownership of the company by the shareholders and each shareholder is usually given one vote per share to elect the company’s board members.
  • Preference shares have first right, ahead of ordinary shares for dividend payments and for assets if the company is liquidated.

How a stock exchange works

 

The New York Stock Exchange (NYSE), the London Stock Exchange (LSE), Tokyo Stock Exchange and the JSE Limited (JSE) are all, simply, markets for shares. Stock exchanges have two purposes. Firstly, they are places where traders can buy or sell shares and, secondly, companies can use them to raise cash to expand their business by selling new shares to investors.

Since 1996, the JSE has not had a physical location for its trading floor as it uses an electronic trading system. It earns revenue from charging companies listing fees and stockbrokers pay for using the trading system.

 

Stock exchanges provide investors with two advantages:

  • They reduce the risk of investing by providing a transparent pricing mechanism for trades.
  • They police listed companies. Stock exchanges operate in a strict regulatory environment and companies have to comply with stringent listing requirements.

Investors use share indices to track the performance of the underlying shares and sectors. When we refer to “the market”, we’re actually referring to an index that is a proxy for all the shares listed on that exchange. In South Africa, this is the JSE/FTSE All Share Index (ALSI). Other global market indices include the FTSE (Britain), the Dow Jones (USA) and the Nikkei (Japan).

An index is defined as “a statistical measure of the changes in a portfolio of shares representing a portion of the overall market”. That means that when an index is up, most share prices have increased and vice versa.

 

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What makes share prices move?

 

In a nutshell, the forces of supply and demand are the key determinants of changes in share prices. In the simplest terms, the share price will go up if more people want to own a share than are prepared to sell it. Over time, a share price will track the underlying trend in the company’s earnings: if earnings (and dividends) grow consistently, the share price should follow.

But there are other aspects that affect investor appetite for shares including the performance of international markets, general economic growth, sector or company-specific news, share buybacks and futures trading. An old adage goes, “When Wall Street sneezes, the world catches a cold”. Although the influence of US share prices is no longer as important to the JSE as it once was, the correlation between movements and international share prices increases in times of uncertainty.

 

Overall, share prices tend to go up when the economic news is good as this means companies should see their earnings increase. In addition, good news from a certain sector or company can drive share prices up as investors expect good future earnings.

 There are other buyers of shares apart from investors, including companies (through share buybacks) and futures traders. They also affect the demand/supply equation.

  

The risks of investing in shares

 

We’ve all heard that there’s no such thing as a free lunch – and this is as true of investing as anything else. Over time, shares have outperformed other asset classes – like government bonds, property and bank deposits – but this comes at a cost.

 That cost is that investing in shares is riskier than other asset classes. The old adage “high risk, high return” means that an investor who takes on the higher risk of investing in shares expects a higher return for doing so.

 

These are some of the risks of investing in shares:

 

  • Share prices can – and do – go down as well as up. Investors can reduce their risk by doing their homework and always knowing exactly what they’re investing in. That includes evaluating “tips from friends”.
  • Some shares can be illiquid. This means that they can be difficult to trade, often because there is a controlling shareholder who owns a large percentage of the company and is not selling those shares on the market. This means that a share can be difficult to sell. To avoid this, invest in more liquid shares.
  • Companies do not have to pay dividends. This is not necessarily a bad sign if the company is keeping that money to invest in its future growth, but is a risk for shareholders who bought that share for the dividend income.
  • If a company goes bankrupt, shareholders may lose the entire value of their investment. Ordinary shareholders only receive what’s left over once creditors and preference shareholders have been paid their due.
  • Companies can disappoint the market by reporting lower than- expected earnings. This can mean the share price either falls or lags behind the growth of its peers.
  • Share prices factor in the market’s view of management’s competence and integrity. Scandals, such as the revelation of fraud or poor corporate governance, can hurt the share price.

 

But you shouldn’t be frightened off investing in shares. Most listed companies are well-run businesses and their share prices should increase over time.

 

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