What a share actually is, and how index funds work
Buying a share makes you a part-owner of a company. Index funds let you own a small slice of hundreds of companies at once.
The short version
- A share is a unit of ownership in a company.
- Share prices move with expectations of a company’s future profits.
- Index funds track a whole market index at low cost.
- A share’s price on its own says little about whether it is cheap or expensive.
Companies raise money in two main ways: borrowing it, or selling part of the business. A share, also called a stock, is one small unit of that ownership.
If a company is divided into a million shares and you own one thousand of them, you own a tenth of a percent of the business. That ownership is what gives a share its value, and it is also why shares can rise and fall so much.
A brief history
The idea of dividing a business into tradeable pieces is centuries old. The Dutch East India Company, founded in 1602, sold shares to the public, and those shares changed hands in Amsterdam in what is often described as one of the first modern stock markets. Organised exchanges grew up in London, New York and elsewhere over the following centuries.
A crucial legal idea is limited liability. In most modern companies, shareholders can lose what they paid for their shares, but they are not personally responsible for the company’s debts beyond that. This made it far less risky for ordinary people to invest, and helped companies raise money from large numbers of investors.
What owning a share gives you
As a shareholder you may receive part of the company’s profits as dividends, and you usually get a vote on some company decisions, such as electing the board of directors. You also share in the risk: if the company does badly, the value of your share can fall, and if it fails, you can lose what you paid. In a collapse, lenders and other creditors are generally paid before shareholders, who are last in line.
Not every company pays dividends. Some prefer to reinvest their profits in growth, and shareholders then hope to benefit from a rising share price instead.
How shares reach the market
- Private ownership. A company usually starts out owned by its founders and early investors.
- Listing. When it wants to raise more money or let early owners sell, it can offer shares to the public, often through an initial public offering, and list them on a stock exchange.
- Trading. After that, most buying and selling happens between investors. When you buy a listed share, you are usually buying it from another investor, not from the company.
Why prices move
Once shares are listed on a stock exchange, investors buy and sell them from each other. The price reflects what buyers will pay right now, which depends largely on what they expect the company to earn in future. News about profits, products, competitors or the wider economy changes those expectations, so prices change too. Interest rates matter as well: when safer investments pay more, investors may demand a lower price for riskier shares.
In the short run, prices can also swing on mood, rumour and the flow of money in and out of markets. Over longer periods, a company’s actual profits tend to matter more.
What an index is
A stock market index tracks a group of companies to show how a market is doing overall. Well-known examples include the S&P 500, which follows 500 large US companies, and the FTSE 100, which follows 100 large companies listed in London. The Dow Jones Industrial Average, first published in the 1890s, is one of the oldest.
Most major indices are weighted by market capitalisation, the total value of a company’s shares, so the biggest companies have the most influence on the index’s movements.
Index funds
An index fund buys the shares in an index so that its value rises and falls with it. Instead of trying to pick winners, it holds the whole market segment. Because little research or trading is needed, index funds tend to have low fees, and they spread risk across many companies.
The first index fund for ordinary investors was launched by Vanguard, the firm founded by John Bogle, in 1976. It was widely mocked at first; the idea of deliberately settling for the market’s average return seemed odd. But research over many years has found that most actively managed funds fail to beat their benchmark index over long periods once fees are taken into account. Index funds have since grown into one of the largest parts of the investment industry. Many are now sold as exchange-traded funds, which trade on a stock exchange like a single share.
Common misconceptions
- “A low share price means a share is cheap.” The price per share depends partly on how many shares exist. What matters is the price compared with the company’s profits and prospects.
- “An index fund cannot lose money.” It can. It follows the market down as well as up, and whole markets have fallen sharply in the past.
- “Diversification removes all risk.” Spreading money across many companies reduces the damage any one failure can do, but it does not protect against a broad market fall.
What is still uncertain
The rise of index investing has raised its own questions. Because the largest companies carry the most weight, a few firms can dominate an index. Some economists and regulators have also asked what it means when a small number of large fund managers hold sizeable stakes in many competing companies. These debates are ongoing and unresolved.
Before you invest
Shares can fall as well as rise, sometimes sharply. Investing usually makes most sense for money you will not need for several years. Costs, taxes and rules differ between countries and products. This article is general information, not personal financial advice; if you are unsure, consider speaking to a regulated financial adviser.
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