What is the Stock Market?
Children often ask what is something for and the simple questions are often the hardest. The Stock Market is a mechanism for companies to distribute ownership among lots of investors. It might seem odd for an owner of a business to sell bits of his business to others. After all, if it is such a great company why would you want other people to own it?
The reason, usually, is that that the company needs a wider capital base to spread the risk. It is possible to fund a business almost entirely through debt, like most of us do when buying our first house. But the cost of the interest can be a burden and may constrain the company from spending more to invest in new opportunities. By inviting others to share the risk, by selling shares in the company and raising capital, the company gets access to funding without having to pay interest on it straight away.
One of the best descriptions of a share can be found on this excellent blog.
Of course investors in a company will expect to see a return for taking that risk of partly owning a business but without controlling it. That return will normally come as an increase in the value of the business, reflected in a higher share price and through dividends that the company pays out from the cash it generates after paying its bills and investing for the future.
It is these shares that are traded on the stock market and provide an indication of how much a company is worth. Valuing a company, through its shares, is not a precise science and depends on such things as inflation, interest rates, the state of a company’s balance sheet and, most importantly, its future prospects. Owning a share is not the same as lending money to a company. It is riskier because there is no obligation by the company to repay in the same way it has when it borrows money from the bank, or the bond market, which is just a market for trading debt. Because shares are riskier than loans, whether bank debt or bonds, they should offer a higher return. Of course the stock market is continually changing as companies react to changes in technology, population and world events such as rising oil prices. But over the years the stock market has proved to be a good place to invest over the long term as the next page shows.
The UK stock market is made up of about 700 companies covering virtually every industry, profession and trade. Each company is unique, but clearly some share features with others. For example, the oil companies all react to changes in the oil price in roughly the same way and banks respond to news on house prices or interest rates in much the same fashion. Most British companies report their results twice a year; a final set of accounts at the year end and interim results after the first six months. In addition to that companies will update the stock market, and hence investors, a few months before they report the results just to let them know how things are going. There is also a requirement that companies notify the market if there are any significant developments, good or bad, at any stage so that the trading in shares is done by everyone on the most informed basis.
The days of “inside information” being passed to a few select investors for their gain are mostly gone. Digesting and interpreting all this news, at least four announcements from each of 700 companies, is the job of the investment analysts. These experts know their industries very well and are adept at interpreting every nuance and signal from the companies, as well as other sources, to generate forecasts of earnings and dividends to determine if the shares are worth buying or selling. That information is used by fund managers to construct a portfolio of shares that they think will deliver good returns. And it is the funds that these managers run that provide the usual mechanism for the public to invest in the stock market, either through pensions, life assurance or unit trusts. But which one do you choose?