How to Make Money in Stocks
The first thing you’ve got to do if you want to make money in stocks is boil down every part of the animal — lips, ears, hooves — everything. Flavor’s flavor! And use a lot of water, because the more water you use, the more stock you end up with.
Oh, sorry, you want to make money in stocks, like equities! Okay, that’s a lot less messy than your grandma’s beef stock.
How to make money in stocks
Here are two statements that are both true. In any given decade, a lot of people have gotten rich investing in the stock market. In any given decade, a lot of people have lost everything investing in the stock market. You’d probably like to figure out a way to be among those in the first sentence. We’ll do what we can to load you up with info, but the first thing you must always remember is that investing in stocks is inherently risky, and no matter how much you know, you’re always at risk of losing some, or even all of your investment.
The first cardinal rule of stock market investing is: Do Absolutely Nothing. What do we mean by this? If you invest in the stock market and start paying attention to all the opinions shared on financial news, you’d pull your money out of the market as soon as conditions started looking bad and probably just as quickly when things started looking too good. Emotions are the enemy of wealth creation. This process of meerkatting in and out of the market is what’s called market timing, and it’s consistently shown to be a losing investment strategy. The quality you need to be a successful investor is what the French call sangfroid — imperturbability in the face of a lot of noise. Money invested in the stock market grows best when left alone in both up and down markets.
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Be boring and diversify
The next way to make money in the stock market might seem a bit counterintuitive. Yes, it’s absolutely true that a modest investment in Amazon back in 1997 would probably mean you’d own your own continent now. On the other hand, if you’d put all your money on Snapchat in 2017 or Twitter in 2014, you might be living above your parents garage right about now. Picking individual stocks is a lot like playing the lottery with your life savings.
The top performing 4% of stocks accounted for the entire wealth creation of the US stock market since 1926, which means there have been a few very, very big winners (like Amazons) and many, many more loser stocks. Why would that be? Think about it: when you’re buying a stock, you’re buying it from someone who’s selling it. The seller has decided the stock is worth selling at say, $10 dollars a share because she’s sure it’s definitely going to go down, but you’re sure it’s definitely going to go up. Who’s right? What makes you so sure you’re so much smarter than that seller?
There happens to be one well-documented method to make money in the stock market without having to pick between the winners and losers. You could buy a whole lot of different ones, like hundreds of them, in hopes that the markets will continuing performing in the future as they have been for the last 100 or so years. Harry Markowitz, a Nobel Prize winning economist, championed an investment strategy called Modern Portfolio Theory that posits that the key to effective investing is diversification. By investing widely, the theory goes, you’ll enjoy robust stock market results while protecting yourself from crushing downside when a specific stock or sector falls precipitously.
See, even as some stocks have risen and others fallen, stocks as a group have risen; in the 1880’s, when it was first created, the Dow Jones Industrial Average stood at 62.76, and despite cataclysmic events like the Great Depression and the recent Global Financial Crisis, it now sits well over 20,000. (Be warned, though– investments are speculative and understand that past results should never be understood to be guarantees, but rather imperfect predictors of future performance.)
Famously rich stock picker Warren Buffett has spent the last decades discouraging pretty much everyone not named Warren Buffet from trying to make money picking individual stocks; he instructs his heirs that when he’s gone, they invest the lion’s share of their inheritance in low-cost market hugging funds. Studies show that diversification, that is, making sure your eggs are divided into a whole bunch of different baskets, as well as allowing for long investment horizons, happens to be a pretty great two-part strategy to counteract the natural volatility of the stock market. Historically, the short-term risk of investing in the S&P 500 dissipated over time.
Fees: The Enemy of Making Money in the Stock Market
Above, we discuss how people often lose money in the market. They bet on a stock or a few stocks, and they bet wrong. Diversification can help counteract that. But the other way to lose money is far more insidious. What if your investment went up in value, but not enough to outpace the drain caused by the fees you’re paying. Which brings us to cardinal rule #2. Keep Fees Low. Fees are basically investment vampires that survive by drinking up all your gains and your job as an investor is to become Abraham Van Helsing, vampire fee killer because studies have shown over and over again that fees are directly predictive of returns in a very simple way; the higher the fees, the lower the returns.
As luck would have it, the same strategy that allows you to diversify also allows you to keep your fees low. Index funds and many ETFs represent what’s called “passive investing,” a term that means that no human is involved in managing the investment. In many cases, a computer algorithm allows the passive investments to mirror the market as a whole or an index like the S&P 500. Investments like mutual funds are considered “active” investments, meaning a (very well-paid) fund manager and her staff will make daily decisions about buying some stocks and dropping others for the fund. B-school labor doesn’t come cheap, and the fund manager and staff salaries are passed on to you in the form of management expense ratios (MERs), a percentage of the entire value of the fund that’s deducted annually regardless of the performance of the fund. The average MER on American mutual funds is about 1%, in Canada it’s closer to 2%, and the UK’s right in between those two. These may not seem like huge numbers, but check out the math of one Toronto-based investment advisor who demonstrated that a small-seeming fee of 2% could actually decrease investment gains by half over the course of 25 years.
These fees would certainly be justifiable if there was evidence that actively-managed funds outperformed passively managed ones enough to justify those fees, but in fact tons of studies show that over the long term, the vast majority of professionals paid to pick stocks fail to outperform the market as a whole.
Can you make a lot of money in stocks?
Yes, you can, if you invest well. You can also lose a lot. This doesn’t mean you should invest with hopes to get rich in a short period of time. It rather means that happens to be a set of practices which, if followed, and if history is any judge, will increase the probability that your portfolio will increase slowly over time. As our friend Warren Buffet, aka, The Oracle of Omaha, said not long ago, had someone invested $10,000 in an index fund in 1942, it would today be worth $51 million. That’s a very patient investor. You should be one too.
But, you counter, what about Amazon? It’s true, if you had access to a time-traveling Delorean and invested in Amazon or Apple or Netflix when they first IPO’ed, you would have made a lot of money. But you can also lose a heck of a lot of money in stocks, as the famous debacles like the Pets.com’s IPO show. Pets.com, which seemed like a great idea to a lot of smart people, went as high as 14 dollars a share only to fall to 22 cents before disappearing altogether.
Do you feel like you have the magical skills to tell the difference between tomorrow’s Amazon and Pets.com? If you do, you may want to follow the so-called 5% rule of investing. Many experts say that in orderly to be properly diversified, no one stock or sector should represent more than 5% of your total portfolio.
What makes stocks go up and down in value?
There are a variety of technical reasons why stocks go up and down, and on the television, you’ll hear lots of news about stocks rising and falling based on factors like earnings per share. You might want to take a deeper dive on those issues. But to take a somewhat more basic view, stocks rise and fall based on very simple issues of supply and demand. If a lot of people decide at once that a stock is undervalued, they’ll all try to buy it at the current price. Because there won’t be enough stock to satisfy all those interested buyers, demand will exceed supply, which will naturally drive the price up. Conversely, if lots of people decide they want to sell their stock at once, this will create a supply that exceeds the demand, and the price will fall until the price reaches a state of equilibrium, a condition in which supply and demand are the same.
One thing that will provide some valuable insight into stock pricing is the concept of “equity risk premium.” Stocks, as you probably know by now, are a riskier investment than government bonds. In exchange for the risk of losing some, or even all of their investment, investors expect to be paid a premium, that is, more than they would make if they parked their money in a very low risk investment like those bonds. This concept keeps stocks viable; if a stock wasn’t expected to outperform the risk-free rate, investors would just stick with the safe money and a stock price would crater. So one of the most important responsibilities of a company CEO is to do everything she can to make sure that investors get bigger rewards in exchange for their risk than they would parking their money in something safe like bonds. A competent CEO knows all about the equity risk premium and does everything she can to make sure the stock price at the very least outpaces the rate of return of a government bond. A lot succeed spectacularly, and quite a few fail too.
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