You can make money lots of different ways when you purchase stock in a company. By buying shares in a company you’re taking part in the economics of that company. You’re voting with your money that a company will do well over time. “Doing well” is different for each stock because of many different factors. I run my own portfolio. I pick individual stocks for the majority of my holdings but also own funds and alternative assets.
There are three main ways you can make money from buying stock:
1) Earnings increase – A company earns more money than it did last year. A big factor on the return that you make will be the revenues and subsequent earnings of a company. Public companies report earnings every quarter. Analysts estimate what the company is forecasted to earn every quarter. If the company misses expectations, even by a penny, it can send the price of the stock down. Conversely, if the company beats expectations, the price of the shares will likely go up. This is one way to make money of stocks: appreciation.
For example, if I purchase 1,000 shares of Whole Foods Market (WFM) at $30 and the stock increases to $40 per share, I just made $10,000. This happens frequently in the market. Stocks tend to rise over time but can also decrease substantially. You have to always manage your risk. The #1 rule of investing is to protect your principal at ALL COSTS. If you lose 50% on a stock, it takes 100% increase to get back to even. This could take years to do.
As a side note, I’m not a huge fan of quarterly earnings calls. This seems too frequent for me. Stock prices jump up and down way more often than they should because of this. One of your biggest advantages over institutional investors is time. You don’t have to worry about pleasing investors. You can hang onto a stock through thick and thin without pressure to sell or perform.
2) Dividends – Many companies pay dividends. More than 80% of the S&P 500 stocks pay dividends. The percentage you’ll receive depends on many factors: growth stage, management, cash flows, earnings per share, sector, etc.
For example, telecoms pay above average dividends but they also don’t increase their dividends at a high rate. Verizon (VZ) will pay you around 1.25% per quarter for an annual yield of 5%. This is guaranteed money – that is guaranteed to the extent that Verizon continues to earn money. You’re pretty safe with this one.
Dividend growth stocks are some of my favorite stocks to own for the long term. I like to be paid while I hold a stock. Ideally, that payment will increase over time. A company that pays a 5% yield and grows its dividend at 10% per year will have a 10% dividend yield after 7 years. That’s incredible! Imagine getting a 10% yield on your stock after owning it for 7 years. With a little patience you can beat almost any prevailing market investment.
3) P/E Expansion – Market participants bid up the price of a stock because they believe the company is worth more than it’s currently valued. A stock is priced based on what the collective group of investors want to pay for it. Two stocks that earn $1 per share a year may have wildly different stock prices. Seems odd, right? Investors are simply willing to pay more for companies that grow at faster rates or are in a sexier industry.
For example, let’s say you bought Amazon back in 2008. You would have purchased a stock that had a P/E ratio of around 35. This means that investors were willing to pay $35 for every $1 that Amazon earned for the year. Fast forward a few years and investors were willing to pay $200 for every $1 that Amazon earned. Amazon doesn’t need to increase its earnings and you’ll still make money. Market participants are simply bidding up the stock because they believe the company will grow faster.
You should start to worry when all of the gains you’re getting in stocks is due to P/E expansion. Because sooner or later there will be P/E compression. What comes up must come down. Not necessarily but this happens often. The pendulum swings from overly optimistic (HIGH P/E RATIOS) to depressingly pessimistic (LOW P/E RATIOS). I use Benjamin Graham’s guidance when allocating capital during bull markets. I’m not afraid to reduce my exposure to stocks if the market is showing signs that it’s in a late stage bull market.
You can also make money by betting against a stock. This is called selling a stock short. In this case you borrow the stock from your broker to sell before you buy it. Then as the stock goes down you buy the stock back at some point. So you’re selling high and buying back low.
I used to do this a lot more often than I do now. It’s super risky and you can lose a lot of money. I didn’t find that it was worth the risk and also never really made big money in this. I can’t recommend that anyone sell stocks short. I would recommend buying put options to protect against market losses. This is a pretty prudent way to insure against losses.
Ways to Buy Stocks
1) Buy individual stocks in companies. When you buy individual stocks in companies you’re investing directly into the company without ongoing fees. There are generally very small commissions for buying and selling a stock (around $5 each way). One of my favorite reasons to buy individual stocks is because there are ZERO ONGOING fees. Nada. Fees are your enemy. Low fees can be okay if you’re smart about it.
Some folks I talk to think investing in individual stocks is riskier than funds. I would argue that you could set up your portfolio to have a similar risk level to that of a fund of stocks. See below “How Many Stocks Are Enough” heading for more information on the risk of individual stocks.
2) Buy stocks through funds. You could also just buy a S&P 500 index fund and call it a day. Warren Buffett would argue that many people would be better off buying the S&P 500 and calling it a day. For a lot of folks it makes sense to buy an index fund and spend the rest of their day hitting golf balls. I buy index fund shares through my 401(k).
There are a couple reasons I don’t like the influx of investors buying into index funds and ETFs. The main thing that bothers me is that when people buy an index fund, they have no idea what the valuation is. They’re buying blind. How do they know it’s a good investment based on the price they’re paying? This goes against what Buffett says about investing like businessman.
People who blindly buy the S&P 500 every two weeks may be doing themselves and the market a disservice. They’re not figuring out which stock represents a good value. They’re giving their money to a fund company that HAS TO buy the stocks in the index to get the proper allocation. So the individual investor is forcing the fund manager to buy blind as well. You can see how this could be a huge problem someday. Stocks could get so overvalued because of investors buying just to buy. Then when the market turns, investors will sell blindly too, compounding the market’s losses. Shit could hit the fan.
How Many Stocks Are Enough?
A study by Elton and Gruber found that the benefits to diversifying diminish after an investor has twenty stocks in their portfolio. After holding just twelve stocks, in fact, most of the benefits of diversification are maximized. A good way to look at this is to look at the standard deviation of an entire portfolio as stocks are added.
To show this point, you can look at portfolios with different numbers of stocks in them. If an investor only has one stock in his portfolio, then the standard deviation (sigma) of his portfolio has a wider range than the S&P 500.
Over the course of any 12-month period, the S&P 500 index has a 68% (one standard deviation) chance of returning between a gain of 34.1% and a loss of 9.8%. This is a statistical measurement tested to be accurate.
A one stock portfolio may have a 68% chance of returning between a gain of 50% and a loss of 30%. This is hypothetical; all stocks have different returns related to standard deviation. To diversify away from this chance of a large loss, the investor adds another stock to his portfolio. Now with two stocks, there is a 68% chance of returning between a gain of 45% and a loss of 25%. Notice how the gain and loss are both trimmed. The investor’s risk went down and with it his expected return also went down.
As you keep adding stocks, the expected gain and loss go down. This happens quite rapidly until you hold about ten stocks in your portfolio. As you add additional stocks to your portfolio beyond ten, the marginal benefit of diversification decreases rapidly. So much so that there is little benefit to diversifying after you hold twenty stocks in your portfolio.
There are many ways to make money off of stocks. There are 3 main ways that you’ll make money off stocks and a couple ancillary ways. The main thing to remember is to protect your principal at ALL COST. You can do this by properly diversifying your investments across different asset categories (risk-free, core, alternative) and different asset classes (bonds, stocks). Use the Triad Portfolio Strategy for allocating capital and you’ll be in good shape.