What are stocks and shares? How do they work? How did they arise historically?

The origins of present-day share trading go back a long way. As early as the Mesopotamian Bronze Age, in 2500 BCE, merchants made contracts for engaging in businesses such as exporting textiles and cereals or importing Egyptian gold, Anatolian copper and Persian timber.

Those rudimentary arrangements were inscribed on clay tablets, but they already clearly stated how much money the "shareholder" had contributed and what percentage of the business venture he became "owner" of.

British historian Niall Ferguson explains it in his indispensable essay 'The Ascent of Money: A Financial History of the World:' the idea that an "enterprise" can be "chopped up and sold in tens, hundreds or thousands of parts is very old, and marked a formidable qualitative leap for the feasibility of ambitious commercial ventures."

If a merchant did not have enough financial muscle of his own to undertake an expedition to buy cedar from Lebanon, why not enlist to his business a small army of people ("investors") who would be willing to help out in the hope of making a profit, even at the risk of losing what they had invested?

Which company was the first to have shareholders?

This is the seed of the present concepts of "shareholder,” "shareholding" and "investment." The idea was adopted, at increasing levels of complexity, by the merchants' exchanges that began to proliferate in Europe from the 12th century onwards.

In the 15th century, according to Ferguson, there already existed in the commercial exchange chamber of the Flemish city of Antwerp a thriving system of buying and selling loans or bonds of different companies that resembled a modern stock market.

However, the first company in the modern sense of being divided into a large number of equal parts (shares) to be bought, sold and exchanged in the coffee houses of London—the informal venues where financial business was transacted—was the East India Company, as early as the dawn of the 17th century. Modern "stock markets" were thus born.

For the first time, the funding of major ventures and mitigation of business risk were systematically addressed. And the coffee houses, with their somewhat anarchic "Persian market" approach, would eventually be replaced by the London Stock Exchange (LSE), which opened in an alley near St. Paul's Cathedral in 1801.

Ferguson explains that at least a few of that first generation of East India Company shareholders didn't quite know what they were getting. They were given a piece of paper attesting that they now owned an infinitesimal part of a huge company, with hundreds of trading posts across several continents.

This was a financial abstraction that was hard for a layman to understand, yet it worked well in practice. Even in its darkest years, such as those between 1839 and 1842, during the Opium War, the Company distributed among its "subscribers" or shareholders returns of 8 to 95 percent.

What are stocks and shares in the modern economy?

In modern terms, we can say that shares are the parts into which the capital of a company is divided. Each individual investor holds a certain number of these equal shares (which are identical to each other): this makes that investor the owner of the percentage of the company that these shares account for. The total value of the company's shares is known as “market capitalization.”

Consequently, shares are units of ownership from which a range of rights arise, such as the right to receive timely information on the company's operations and financial performance, to attend company meetings, to exercise voting rights and to collect dividends. These rights are regulated under the general principles of the stock markets, but also according to specific provisions, such as the rules for attending shareholders' meetings or the shareholder remuneration policy pursued by each company.

As economist Leopoldo Abadía explains in his informative essay 'Economics for dummies,' the general principle is simple: a person sets up a company and divides its initial capital into a series of parts, each one "represented by a series of small pieces of paper which we call shares." After some time, when the business is fully established, the owner may decide to sell a certain number of these shares on a regulated market, i.e. "a stock exchange."

From then on, the value (quoted price) of the shares will no longer depend on the percentage of the initial capital they represent, but on the "reputation" of the selling company and "the law of supply and demand."

Types of shares: listed, fractional and split

1. Listed shares

In the example given by Abadía, we would be talking about listed shares, i.e., those that can be freely traded on the stock market. In technical terms, shares are issued in the primary market (when the company puts them into circulation with the aim of raising funds from the public) and then traded on the secondary market, the stock exchange. There are also unlisted shares, i.e., shares issued by companies that have never been listed on the stock exchange or that for some reason have ceased to do so.

The latter type of shares can also be bought and sold, but without the assurance that their being included in the overall system of stock market transactions would imply.

2. Derivatives.

To add complexity to an otherwise simple formula, there are a number of products in the market that are derived from shares, or have shares as the underlying asset, such as futures and call or put options.

In the case of a futures transaction, the investor undertakes to buy or sell the underlying securities at a future date at an agreed price, whereas in the case of options, the investor has the right to exercise the purchase or sale transaction at a time to be decided within the option expiration period and for the agreed price (strike price), in exchange for a premium.

3. Fractional shares.

Another variant is the opportunity offered by some investment platforms to buy fractional shares. In other words, to acquire not a whole share, but just a part of it. Fractional shares are intended for assets trading at very high prices, where the stock, as in the case of Berkshire Hathaway Inc, Lindt & Sprungli AG or NVR Incorporated, sells for several thousand euros, an amount that is not affordable for all potential investors.

As finance expert Ismael de la Cruz explains, "The bad news is that not all brokers currently allow buying fractions of shares. Over time, it will end up being a generalized practice, but it isn’t at present."

Cruz says that some platforms make it possible to become a shareholder of one of the lower-priced companies at a more affordable price, which also favors diversification, since the money saved by choosing a fractional share instead of a full share can be invested in other securities.

4. Stock splits.

Indirectly associated with this possibility is the increasingly common practice at some companies of conducting a 'stock split.' The company increases its number of shares by multiplying them by a certain number and, consequently, dividing the value of each original share in the same proportion.

Innovative companies such as Tesla, Nvidia, Amazon, Alphabet (Google) and Apple have made use of this mechanism, which provides higher liquidity to the company's assets, thus improving trading volumes and preventing individual shares from reaching such high market prices that they are potentially a deterrent.

A stock split is, in short, a division of the company's shareholding, designed to attract new investors. It has a neutral effect on the existing shareholders: if, for example, a shareholder becomes the owner of three times the number of shares, these will have their market price divided by three and will continue to represent the same percentage of the company's total capital stock.

Apple is perhaps the most striking example: it had already made a 2-for-1 split in 1987 and repeated the transaction in 2000 and 2005. In 2007, Apple opted for a 7-for-1 split to bring the value of the individual share below the $100 barrier, which at the time was seen as a potential deterrent. Finally, in 2020, the number of Apple shares multiplied yet again, this time by four.

As Niall Ferguson would say, if the East India Company were still in existence, by now its number of shares would have multiplied many times over.