Stock markets are risky and tumultuous, so why bother?
Stock prices and news are widely covered in mainstream media but rarely are the most fundamental questions answered: Why would anyone want to own stocks? What are the advantages of equity investing?
In short-form, the advantages of equity are:
- Capital Appreciation: Equity ownership allows investors to participate in and benefit from the fruits of economic growth and expansion.
- Ownership: When you buy stock you are buying partial ownership of a company. As such, you get to vote on the people who run the company and have a right to the company’s dividends—and you don’t even have to show up for work!
- Inflation Protection: Inflation is defined as a general rise in the prices of goods and services. Investing in companies that can pass on inflation to their consumers in the form of higher prices is a good way to keep yourself relatively insulated from the wealth-eroding effects of inflation.
- Income: Many companies regularly pay dividends to their shareholders. As an equity owner, that means you get a portion of the company’s income.
Now that we’ve established the main reasons why you would want to own equity, it’s worth a conceptual dive to explain, in detail what equity is.
When you buy stock on the LSE, you are buying an equity stake in that firm. The same is true on every stock market in the world. Your share of stock represents your fractional ownership of that company’s assets after all of its debt has been satisfied. It is referred to as residual ownership because that asset—say, a company like Royal Dutch—only has value once the money it owes to its creditors is accounted for.
Publicly listed equities are bought and sold by investors on public or nonpublic exchanges. These shares are traded at a price that represents the market’s view of the value of the firm’s assets and future growth prospects, after accounting for its debts. These shares are initially sold to the public when the issuing firm wants to raise funds in the public market place—the initial public offering (IPO).
These fractional ownership interests will fluctuate in value once listed publicly based on the market’s perception of the firm’s value and prospects. If the market believes the value of the company is higher than previously estimated, there will be more people buying the company’s shares than selling, and the price will rise. If the market believes the company is less valuable, share prices will fall due to a disproportionate amount of selling.
At their core, equity investors believe that a company’s value will rise between the time they buy shares and the time they decide to sell. But there is another component to equity returns: dividends. A profitable company that generates enough profit to cover its debt service costs will often share that profit with investors in the form of a dividend. Dividends are not guaranteed like coupon payments and not all firms pay them. They can also vary substantially from quarter to quarter. But, baked into a stock’s price is both any current dividend payments and the expectation for future dividends. A stock’s return is therefore not based entirely on the expectation that shares will be worth more at some point in the future than they are today; rather, on a combination of factors. In this way, a stock is a forward-looking estimate of a company’s value.