How Investing in Shares Makes (or Loses) You Money
Remember that buying a share in a company means just that: you own part of the business. So if the company does well you should get your share of that profit. But if it does badly you could lose some or all of your money.
That's why it's important to understand what you are buying into, how you expect it to make you money, and what might happen if it all goes wrong. This article will explain the main ways that companies give a return on investment to their shareholders.
A Share in the Profits: Dividend Payments
When a company makes a profit they may pay all or some of this to their shareholders as a dividend payment. The profits they don't pay out are called retained earnings and may be used to invest in growing the business, acquire new businesses or as a buffer against bad times.
A dividend payment is a form of investment income (as opposed to a capital gain—for the difference between investment income and capital gains see this article here). In most countries, dividends are taxed as income, possible with some adjustment for corporate taxes that have already been paid.
Some companies have a policy of paying a regular dividend (which increases with time). This is attractive to certain kinds of investors, those who prefer regular income such as some pension schemes or individual pensioners.
A Share in the Value of the Company: Capital Gains
The other way you can make a return on your shares is a capital gain: in other words, the market price of your shares goes up.
For large companies where shares are bought and sold frequently this is relatively easy to measure (although remember that a capital gain is never really yours to spend until you have locked it in by selling your shares). But for small companies and startups, it can be hard to determine the market price of the shares until you actually sell them.
Of course, if markets are rational and working properly then the price of the companies share should reflect expected future profits. So the share price and profits are still related—if a bit less directly than with dividend payments. This is more likely to be true for large companies where lots of shares are traded.
Sometimes companies will return money to share holders via a share buyback rather than paying dividends. A share buyback (because it reduces the number of shares that have been issued) will increase the share price giving a return to all investors.
One reason for companies to do this is that some investors prefer to get capital gains (from the share price going up) rather than income (from dividends) for tax or other reasons. It also might be a way they can hit a certain share price target they would otherwise miss.
So How Does This Help?
Knowing this allows us as investors to think clearly about which companies to invest in.
Firstly, you might decide to invest if you believe a company will make good profits in the future which will allow them to return money to you either as dividends or share buybacks, relative to their current price. This is basically an investment philosophy called "value investing" (as made famous by Warren Buffet). This focuses on buying shares in businesses when they are cheap (ie good value).
Or you might believe that the share price will rise because of increased demand (because other investors will buy the shares). The key here is to sell before everyone else does. This is called "trend investing" or "momentum investing". It means following the crowd, but stopping before they turn around and run the other way.
In theory, if markets are behaving rationally, then the first reason and the second reason will always happen together. But in reality it doesn't always happen that way.
Over the long term you'll make more money than most people, if you make better picks than most people. But making good picks is hard and you only really know if it was a good investment with the benefit of hindsight.
But the most important thing is to be happy that your investments suit your circumstances and you get extra return whenever you take extra risks, and you can cope with any consequences of the risks you are taking.
This is more relevant when you invest by picking a few companies to buy shares in rather than a diverse portfolio of investments (for example might be through a passive index tracker fund). But even with passive investing you need to pick which markets and which assets to invest in, so you still have to consider the pros and cons of putting your money into those assets.
Investing in stocks and shares is never simple, always involves putting your money at risk and very little is guaranteed. Thinking clearly about how shares can make you money will make it easier to assess the chance that any given investment doing well for you, and can make sure you are happy with the risks to your money.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2014 Cruncher