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Sunday, 1 March 2009

Sir Hugh Invents the Share and Gets Lost

What's a Share?

In 1553 Sir Hugh Willoughby set sail from England to Russia with the intention of opening the first trade route between the two countries. The idea behind his venture, the Muscovy Company or, to give it its full name (deep breath) The Mystery and Company of Merchant Adventurers for the Discovery of Regions, Dominions, Islands, and Places unknown, wasn’t unusual for the time. All across Europe explorers and merchants were sailing into the unknown in a quest for fame and, particularly, fortune.

The Muscovy Company, though, was unusual in another way. It was the first recognisably modern corporation.

Investing is a Risky Business

The problem with such ventures was risk. Sailing off into the unknown in a small wooden vessel with no maps and few navigation aids was a perilous undertaking. Voyages often came to grief when crews got eaten by unexpected cannibals, drowned on unexpected reefs, were captured by unexpected slavers or simply died through a distain for fresh vegetables and cleanliness.

So, for the investors backing these merchant adventurers, the chances of making any money whatsoever on a single voyage was relatively small with the possibility of a total loss never being very far away. On the other hand if your ship did come in you stood to make an absolute fortune: in the 1600's a pound of nutmeg sold in England for 600 times more than it cost at source.

Would you take such odds? Most people couldn’t, because the risk and the downside was too great. Lose your money in sixteenth century England and the only bail outs you'd see would be the ones in debtor’s prison as you cleaned out the privies for the rest of your days.

This meant that were only a small number of people able and willing to invest in such opportunities because to do so meant you had to have enough cash to equip and pay for a lot of different ventures. One success could pay for many failures and still make you very rich, but you needed to be able to afford such a massive investment in the first place. So, because there were so few people able to invest that much money only a limited number of voyages could be financed.

Enter Sir Hugh.

The Origin of Shares

Sir Hugh’s Muscovy Company was the first so-called joint stock company. This meant that instead of having one single owner the company was split into equal shares (also known as “equity”) so that multiple people could buy a part of the company instead of needing to fund the whole thing. This is, minus a few bells and whistles, much the same structure as the companies we invest in today. So now investors could invest just a fraction of their savings in a single voyage, reducing the risk of a total wipeout.

The beauty of this is that people who previously couldn't afford to invest because they didn't have enough money to finance multiple whole voyages could now do so. They could buy small parts of many ventures and spread their risk. This is the origin of the modern portfolio of shares. Importantly it meant that there was more money - more capital - available to fund exploration and, for England, this was to become a critical factor in the race for global domination.

Trading Stocks – Where Stockmarkets Started

Fairly soon after the joint stock company became popular someone hit on the idea of trading shares, the price of which would fluctuate depending on information (“Russia’s gone to war with England, sell the Muscovy Company!”), fashion (“everyone’s wearing Russian fur this year, buy the Muscovy Company!”) or rumour ("I heard that the Muscovy Company’s ships have been eaten by a giant penguin, sell the Muscovy Company!”). Thus was born the concept of the modern stockmarket and, frankly, not much has changed in the five hundred years or so since.

All the basic concepts of stockmarket investing are present here: splitting a company into equal shares to allow investors to spread their risk by buying portfolios of shares in different companies, the trading of those shares on a stockmarket and the price of the shares varying depending on actual news, rumour or simple high spirits. People could suddenly make money by trading stocks as opposed to simply investing and waiting. Some people became very rich by dealing in stocks – usually because they had inside information – but most lost out – because they were randomly guessing at what was actually happening. Some other things don’t change much either.

Why You Should Limit Your Investments in Nutmeg

In addition foolish investors could now make the same mistakes that modern ones do. So, for instance, they might put their money in ten voyages to spread their risk but get overexcited about the current fashion for nutmeg and invest in ten nutmeg exploration companies. Unfortunately as nutmeg only came from one small group of islands this meant that their spread of investments wasn’t quite so risk free as you might think.

So the voyages might all run into the same storm, or discover that the nutmeg crop they were intending to buy had failed. Or they might find that the Dutch had annexed the nutmeg growing islands and were forcing all the natives to make clogs out of the nutmeg trees (which is approximately what actually happened, apart from the clogs).

So having investments in lots of companies doesn’t necessarily spread your risk if all of those companies have closely related businesses (technically this is known as 'correlation'). That’s as true today for technology stocks or Chinese companies as it was for trading companies in the fourteenth century. Human nature simply doesn’t change that quickly.

So, Exactly, What is a Share?

From this example of the earliest of companies we can see many of the key points about shares:

1. Shares are initially issued to the people who put up the inital investment or capital of the company.
2. Each share constitutes an equal part of the ownership of the company (which is why it's sometimes called equity).
3. Each share entitles its owner to an equal say in the running or control of the company.
4. Each share entitles its owner to an equal share of the profits or losses of the company for as long as the company exists.
5. Shares can be traded after they're issued.
6. Trading is often, but not always, done on a stockmarket.
7. The price at which a share is traded is determined at the time based on the value the buyer and seller put on it.
8. If a company fails (or the ship sinks) you can lose everything but you can reduce the risk of an individual company failure by buying a portfolio of shares in different, unrelated companies; and
9. If the companies in your portfolio are closely correlated because they do similar things then your risk will be higher than if they're in different business areas.

These points together make up most of the basic information anyone needs to understand about investing in shares. They're also really only scratching the surface, and if you're starting to think that this stuff is difficult and ought to be left to "experts" you might find me in agreement, as long as you're careful about how much you pay for their "expertise".

Sir Hugh and The Muscovy Company – The Parting of the Ways

As for Sir Hugh and the Muscovy Company, they had starkly different life experiences. One of the Company’s ships got to Russia and established a trading agreement with the Tsar, Peter the Great, that lasted until the 1917 Bolshevik Revolution. Sadly the inventor of the modern trading corporation was, like many business leaders, a whizz at finance but pretty useless at actually running a company. Captaining one of the ships, he took a wrong turning in a storm, ended up stuck in an ice-flow and died with all of his crew due to a lack of winter clothing.

R.I.P. Sir Hugh Willoughby: financial genius, bloody useless navigator.

Next Post: Investing Basics (2): Shoot the Company - Valuing by Assets

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