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Home > Financing Best Practice > Attracting Small Investors

Financing Best Practice

Attracting Small Investors

by Wondimu Mekonnen

Executive Summary

  • Small investors are individuals who purchase small amounts of stocks for themselves, as opposed to institutional investors such as pension funds.

  • Small investors can deposit money in banks and building societies to earn interest on their savings.

  • Although it has been the traditional belief that money deposited in a bank or building society is safer than an investment in stock, the recent crises experienced by these High Street institutions have eroded that trust.

  • Investments in company stock involves risk, but the rewards can be much greater than from a deposit or savings account.

  • In dealing with small investors, CEOs and CFOs are advised to implement various incentives to keep existing investors and attract new ones.

Introduction

A company is financed by various sources, such as short-term borrowings, long-term debt, and owner’s equity—ordinary shares, preference shares, and reserves. Small investors can participate in most of these. A significant portion of funds finds its way into the bond or stock markets through financial institutions that are the repositories of household savings. Therefore, the size of resources available for financing a company’s activities depends to a large extent on household savings. Small investors are usually individuals who purchase small amounts of stocks for themselves, in contrast to the large institutional investors such as pension funds. Small investors are sometimes referred to as individual, or retail, investors.

In 2005, the Investment Company Institute reported that 91.1 million household investors in the United States held US$56.9 million of various types of equities.1 This constituted 50.3% of all households. The growing number of small investors gives the market depth.

Banks and Building Societies

Banks and building societies depend primarily on household savings, of which they are the main custodians. The amount of interest they offer on deposits and savings accounts can be an incentive to small investors. For their very survival, therefore, it is vital that such institutions understand how to deal with small investors. They have to design incentives to encourage people to save. One way they do this is by offering savings accounts with a variety of earning structures and conditions. The Halifax’s fixed saving term option2 and Abbey’s Individual Savings Accounts (ISAs) offer the kinds of incentives that may encourage household savings.

Companies can raise money by selling bonds to investors. Although in theory, small investors could buy corporate bonds and hold them, they play little role in the primary market. Simply put, bonds tend to be bought and sold in a closed circle of insiders and experts.

Investment in Shares

More and more small investors have become shareholders, and share dealing is no longer a job reserved for city slickers. In the United Kingdom, the Building Societies Act 1986 allowed building societies to demutualize and become public limited companies instead of mutually owned organizations (i.e. owned by the customers who borrowed and saved with the society). A case in point is when the Halifax Building Society announced that it was to merge with the Leeds Permanent Building Society and convert to a plc. The Halifax floated on the London Stock Exchange on June 2, 1997, making more than 7.5 million customers of the Society shareholders in the new bank—the largest extension of shareholders in UK history. Of the new shareholders, 2.1 million were small investors. That is about one-third of all the investors in the Halifax (Snowdon, 2008). A report published in May 2008 reveals that small investors hold a combined total of 770 million shares worth almost £4 billion in HBOS, as the group is now known. Their average holding is 375 shares.

Another example was when Abbey National (now Abbey) was demutualized in 1989, in which 1.7 million small investors held 200 to 300 shares. Abbey was eventually taken over by the Spanish bank Santander (Papworth, 2005). £400 million of Bradford & Bingley’s funds come from small investors (Treanor, 2008),3 who form more than a third of its lenders. The recent nationalization (government takeover) of Bradford & Bingley will mark the end of the line for the last independent former building society to take on bank status.

Risk-taking investors may not wish to be limited to the small amount of interest they can earn on a deposit account, but prefer to take the risk of investing in company stocks. With such investments they can reap the reward if prices rise, although they have to suffer the consequences if prices fall. When markets are rising, what a saver might make in three years from a savings account can be made in a year, or even in months, in the stock markets. Thus, the reward for taking risk can tempt small investors to invest in shares. Companies should therefore make every effort to tap into this potential source of finance.

Anyone can trade in shares by him- or herself or through an agent, called a stockbroker. The quality and speed of market information has improved tremendously. Newspapers, especially the Financial Times, and various websites report movements in share prices. Using the internet, up to date information on share prices can be obtained instantly in the comfort of one’s home. The London Stock Exchange home page4 provides continuous reporting on market movements in the FTSE indices. Similarly, the New York Stock Exchange,5 the largest in the world, provides information on various indices including S&P500, AEX, and Euronext 100 online. As a result, the number of small investors trading in shares has been steadily increasing. Figure 1 shows the growth in equity ownership by US households between 1983 and 2005.6

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Further reading

Books:

  • Lindahl, David. Trump University Commercial Real Estate 101: How Small Investors Can Get Started and Make It Big. Hoboken, NJ: Wiley, 2008.
  • Stowe, John D., Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey. Equity Asset Valuation. Hoboken, NJ: Wiley, 2007.

Articles:

  • Brush, Michael. “A revolution for small investors.” MSN Money (April 30, 2008). Online at: tinyurl.com/cjhbq9
  • Hanson, Tim. “Secret advantages for small investors.” The Motley Fool (January 9, 2006). Online at: tinyurl.com/cdjlo5
  • Lease, Ronald C., Wilbur G. Lewellen, and Gary G. Schlarbaum. “The individual investor: Attributes and attitudes.” Journal of Finance 29:2 (May 1974): 413–433. Online at: www.afajof.org/journal/jstabstract.asp?ref=8798
  • Lian, Tan Kin. “Protecting the small investors.” The Online Citizen (September 22, 2008). Online at: tinyurl.com/2erwxth
  • Luo, Jar-Der. “The savings behavior of small investors: A case study of Taiwan.” Economic Development and Cultural Change 46:4 (July 1998): 771–788. Online at: dx.doi.org/10.1086/452373
  • Malmendier, Ulrike, and Devin M. Shanthikumar. “Are small investors naïve about incentives?” Journal of Financial Economics 85:2 (August 2007): 457–489. Online at: tinyurl.com/2vphlj6 [PDF].
  • Papworth, Jill. “Investors should lose Abbey habit.” Guardian (London) (January 22, 2005). Online at: tinyurl.com/36luklk
  • Snowdon, Ros. “HBOS cash call sets poser for small investors.” Yorkshire Post (April 30, 2008). Online at: tinyurl.com/32tfqb3
  • Treanor, Jill. “Small investors threaten to derail B&B fundraising.” Guardian (London) (June 28, 2008). Online at: tinyurl.com/359b45k
  • Varian, Hal R. “Economic scene; despite the recovery in stocks, some of the forces behind the internet bust are still lurking.” New York Times (July 3, 2003). Online at: tinyurl.com/agkjuj
  • Wilson, Graeme. “Halifax in a fix.” Sun (London) (September 17, 2008). Online at: tinyurl.com/32zjhty

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