Money: Bank on equities to conquer inflation

A BEGINNER'S GUIDE TO; INVESTING IN SHARES: The stock market can be risky, but it is a proven long-term winner, writes Magnus Grimond
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The Independent Online
The stock market should be a home for at least a part of everyone's savings. Shares have proved themselves one of the few long-term winners in the battle against inflation, enemy number one for long-term savers. But what are shares and why do they do so well?

Quite simply, an ordinary share is a scrap of paper or, nowadays, an entry on a computer disk that represents the ownership of a tiny part of a company. Just how tiny is illustrated by British Telecom's share register. Around 1 million small shareholders with holdings worth less than around pounds 1,800 own an average of 220 shares each, stakes that represent just one three millionth of a single per cent of this huge company.

The point though is not how many shares or how much of a company you own as what each share represents. Take BT. With your share comes "ownership" of a fraction of the profits after tax (32.8p last year) and a stake in the assets of the company (pounds 2.42 at the last count). The stock market puts a lot of faith in earnings and they do reflect the value of the company. If earnings are rising, the company is growing and can pay out bigger dividends to shareholders. It also becomes more attractive to a bidder willing to stump up enough money to buy the whole company and grab those profits. As a result, the share price tends to move upwards in line with earnings or, more importantly, in line with how fast future earnings are expected to grow.

There are two ways of getting your hands on this value: through dividends or by selling the shares. The annual dividend represents two payments for most companies, the interim dividend paid after the middle of its financial year and the final dividend declared when the results for the whole year are announced. Add the two together and you get the total dividend for the year. To obtain a direct comparison with other forms of investment like building society accounts or gilts (government bonds) you need to do a further calculation. Adding back the (20 per cent) tax that the company pays on your behalf before you receive a dividend ("advance corporation tax") and dividing the answer by the share price and will give a "yield" figure.

A quick glance at the shares page of any newspaper shows that the average share is yielding around 3.1 per cent, or well under half what a decent instant access account would pay in annual interest. But that is less than half the story. As well as the fact that this dividend should grow the rest of the shareholder's return comes through the rise (or fall) in the price of his shares. Last year, for instance, the typical share returned just over 12 per cent, of which only a little more than a third came from dividends. Since the beginning of 1997 the market has climbed a further 23 per cent, which is probably a signal for the cautious investor to lock in those gains by selling all or some of his shares. But is that the wise course?

The answer is that it depends on your outlook. For stock market aficionados, the world is divided between bulls (optimists) and bears (purveyors of gloom). For the last 15 or 16 years, apart from one or two short spells, the bears have remained firmly in their caves. Since 1981, the London market has grown fat on one of the longest bull markets of this century. But the bears have long memories. With the tenth anniversary of the 1987 crash now just a week away, many are nervous that the peaks being scaled are unsustainable.

But even if there is another crash history still suggests that shares should provide the best long-term shelter from inflation for your savings. Why? Well through that direct link with a company's profits a share represents an investor's own tiny stake in the economy. All other things being equal, the average company's profits will grow in line with the growth of the whole economy, typically around 2 per cent a year after inflation. By contrast, the fixed or interest rate-related returns from building society deposits and gilts have been eroded by inflation over the past 50 years or so.

Of course, some companies' profits grow faster than the economy, some slower and some go bust. Shares clearly carry more dangers. This means investors look for a bigger return to compensate for the extra risk. This "risk premium" varies widely, but has recently averaged around 6 per cent a year more than the return from cash.