I was at a dinner the other evening speaking to a seasoned property investor who, not surprisingly, was bemoaning his capital losses. I asked him how his stock portfolio had performed. His response was that he did not understand "things like that". This was a middle-aged professional of not insubstantial means who knew nothing of shares, so he did not appreciate the importance of risk diversification that we are now so familiar with.
As we learnt last week, index tracker funds will, in theory, rise and fall exactly in line with movements in the markets. However, they cannot outperform a rising or falling market - which is why this week I am talking about active management using shares. So what exactly is a share? The Oxford English Dictionary defines a share as "a part of a larger amount which is divided among ... a number of people ... entitling the holder to a proportion of the profits".
It's that simple. If you own a share in a company, you have a legal stake in the fortunes of that company, reflected in the share price, and a legal say in its control, represented by your voting rights. However, that may not mean that you control the company. For example, a company with 7 billion shares in issue may have a million shareholders. If 10,000 major shareholders - pension funds, banks, investment trusts - own 6 billion shares and we, the other 990,000 investors, own the other billion shares, we are certainly entitled to our measure of the firm's profits in the form of a dividend. But as a group, we do not control the company.
I should add that around 80 per cent of the London stock market is owned by big investors, so the example is relevant. The shares that most people buy and sell are called ordinary shares, also known as equities, and are potentially the most profitable. There are also preference shares, bonds and loan stock, which I will cover in later lessons. Ordinary shareholders receive a dividend from the profits of the company, but will receive them only after other classes of investors in that company, such as preference shareholders, have been paid. And these preference shareholders are the last in line for payment if the company goes belly up, so they take the biggest risk - but can also receive the biggest rewards.
Each ordinary share counts equally. That means one share, one vote, and the same dividend for each share, if the stock pays a dividend. You can vote at annual general meetings for matters such as reinstating board members, as well as at extraordinary general meetings, where, for example, there might be a takeover at issue. You can do all this with just one single share. And guess what? If you disagree with a political or environmental action that a company is involved with, you can use that one share to attend one of these meetings and make your views heard.
As a shareholder, you are also entitled to the firm's annual report. Accordingly, try to think more of yourself as buying the company rather than buying a share. That way, you will feel you have a greater interest in the firm and its products, services, sales, earnings and outlook. Make an effort to attend one of these general meetings, because by doing so you will learn more about how companies are managed and the industries they are involved in.
However, if this is not practical, read the meeting agenda and cast your vote by proxy. The trick to success in investing in shares is to become an active owner. Companies can initially raise money in different ways. But issuing shares presents them with a big advantage, because once the share is issued and paid for by the investor, the money belongs permanently to the company without it having any obligation to repay - even through a dividend.
Get to know your companies well. John McGaw is a financial adviser based in Dubai. Contact him at email@example.com