What are shares?

When a company wants to raise money, it can do so in one of two main ways. First of all it can borrow money, either from a bank or by selling bonds, or by selling equity.

"Selling equity" means a company can actually sell little pieces of itself to investors. The company gets an injection of cash, the investor is then entitled to a proportionate share of future profits.

A "share" is thus a little piece of a company that you can buy, either privately off the market or (for a listed company) on the stock market.

What is the stock market?

The stock market is basically a big auction where people bid to buy and sell shares, as well as certain other financial instruments like warrants and exchange traded funds. Trading takes place on a computer called SEATS (stock exchange automatic trading system) and contract paperwork is handled by an electronic clearing house called CHESS (clearing house electronic sub-register system). The primary market is where new shares are issued, and you buy directly from the company, or their broker or underwriter. Once you have bought shares on the primary market you can sell them to somebody else on the secondary market, or if you prefer you can simply buy from someone on the secondary market and sell it later if you want to.

How do you buy and sell shares?

You usually go through a stock broker, this may mean you deal face to face with an adviser (a full service broker) who will give advice, or you can buy and sell via a discount broker that gives no advice (but charges less per trade). Many discount brokers have a presence on the Internet and by trading via their automated web sites they can charge even lower rates per trade.

You can also do an off-market transfer, which is where you arrange to have a family member's (or some other party's) shares transferred into your name. The paperwork can be a bit of a bother and as far as the tax office is concerned this is no different to a regular buy and sell, so you'll still pay taxes and things.

A third avenue for share ownership is an employer's share scheme, where as part of your pay package you get stock in the company.

What drives share prices?

In the long term share prices go up because companies don't distribute all of their profits as a dividend. Instead they use their excess profits to finance further growth. As a result the value of companies climbs over the long term.

Shorter term effects that contribute to daily stock price changes include company announcements, movements on foreign exchanges, interest rate moves, rumours and a variety of "psychological" causes.

What kind of return can I expect from shares?

Historically, over the last 50 years or so, shares have returned an average of between 7 and 11% per annum, though this fluctuates a lot and over periods of a year or less the return could be over 50% positive or negative. For best results you should hold shares as long as possible, preferably for ever. Shares will provide a constantly growing stream of dividends, and it is these in the long term that you should be trying to live off, not capital gains.

What are the main advantages and disadvantages of shares?

First the advantages:

• Shares typically provide the best returns of any asset class.

• Shares are very tax advantaged, with tax credits attached to most dividends and concessional capital gains tax rates shares are much better from a tax point of view than any other investment.

• Shares are a diversified asset class, you can participate in international as well as domestic opportunities in a huge variety of different industries. Even with a poor economy many industries still make good profits.

• Liquidity is good. Liquidity is the ease of cashing in your investment. Unlike direct property or alternative investments like art, diamonds, gold etc, there is always a ready buyer on the stock exchange. You can't guarantee you'll get a great price, but there will be a buyer there if you need to sell so desperately that you will take a less than wonderful price.

And the disadvantages:

• Share prices fluctuate a lot, which short term oriented investors find very distressing.

• Some companies go broke, and due to the occasional dishonest auditor you won't be able to see it coming. Therefore you need to diversify a lot, though this is easy to do since you can buy small amounts of shares.

• Shares require analysis and hard work if you are going to do better than average. If you don't feel you need to do better than average you can buy an index fund or a managed fund and get a diversified basket of shares without any hard work for you.

• Shares are a high performance asset class, but there is no positive link between inflation and corporate profits. Higher inflation does not mean higher profits, in fact it may be quite the contrary. In times of high inflation shares may have trouble achieving high returns above the inflationary rate, in these times property may provide superior returns.