How to make money investing in stocks: everything you need to know
By A.G.
09:20, 16 June 2020
Basics about stock investing and a brief history
Stocks have been around since 1602 when the Dutch East India Co. issued first paper shares. The first stock exchange was founded in London in 1773. In the US, the Philadelphia Stock Exchange opened in 1790. It was quickly followed by the opening of the New York exchange in 1792, marking the beginning of Wall Street.
It’s important to distinguish between a share and stock of a company. These terms are often used interchangeably in the context of investing. Technically, the stock is a sum of all the shares into which a company’s ownership is divided. A share represents a fractional ownership stake in a company. A shareholder is entitled to a share of a company’s earnings proportionate to their investment. They can also vote on company-specific matters and have a claim on the company’s assets in a case of bankruptcy or liquidation.
A simple way of thinking about buying stocks, that is often ignored, is that you are buying a part of the business. Whether it’s Microsoft (MSFT) or your corner bakery, the concept is the same. At any company, the board of directors and the management team work to maximise shareholder value. In that regard, their goals are aligned with yours.
Today, it’s fairly easy to invest in stocks online and take advantage of owning high-quality businesses.
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How to make money investing in stocks online: key considerations
Before considering how to make money investing in shares, each investor needs to assess their investment time horizon, risk tolerance and target outcomes they are trying to achieve. The CFA Institute, for instance, recommends that investors build an investment policy statement before investing.
Time horizon. Historically, a chance of a negative return for any given year is about 31 per cent. As the holding period increases, the frequency of negative returns decreases. Since the 1920s, investing in the S&P 500 (US500) would always make investors money over 20 years regardless of when the investment was made. Furthermore, most investments exhibit lower long-term volatility.
Risk tolerance. Assessing risk tolerance is crucial to understanding how to earn money by investing in the share market. Riskier investments tend to generate better long-term returns. Looking at history, the S&P 500 returned an average of 9.5 per cent per year between 1928 to 2015. Emerging market equities, on the other hand, have historically earned 12 – 13 per cent per year. Investors with lower risk tolerance might focus on a more defensive subset of stocks and employ strategies to limit volatility in their portfolios.
Target outcomes. Most people choose to invest for a specific reason. It could be to generate a certain level of passive income, grow wealth for retirement or save for a purchase of a home. Different target outcomes necessitate different investments.
So, how to make money investing in stocks?
After pondering their time horizon and risk appetite, investors can consider several approaches to making money in stocks and how to earn money from investing in shares.
Dividends
Dividends are one of the safer and, perhaps, more predictable ways of making money in stocks. Dividends are generally paid quarterly in the US and semi-annually or, in some cases, annually in Europe and Australia. They tend to be predictable because the companies that elect to pay them have large, mature businesses with stable profits and cash flows. These companies often lack significant opportunities for expansion and growth. After covering the costs of running a business, they choose to return some of the excess capital to shareholders through dividends and buybacks.
Long-term investments
Long-term investments make money through a combination of capital gains and dividends. From 1930 to 2019, dividend income accounted for 42 per cent of the total return of the S&P 500, which has varied significantly by decade.
While dividends provide a great source of income, reinvesting them back into the stock market allows investors to benefit from compounding. Compounding refers to earning a return on the principal and accumulated interest. Going back to 1970, 78 per cent of the total return of the S&P 500 came from reinvested dividends and the power of compounding.
Despite their short-term volatility, making long-term investments is a proven example of how to make money in stocks.
Speculation and short-term trading
Speculation and short-term trading are riskier options for making money in stocks. They are more suitable for younger investors with high risk tolerance than an investor close to retirement. Short-term trading often involves leverage or margin trading and can be done through the use of financial instruments like contracts for difference, or CFDs. Speculative investments are usually short-term bets that can be placed in either direction. Going long allows investors to benefit from price appreciation while shorting a stock pays off when the price falls.
Let’s use Tesla (TSLA) as an example of how to invest in the share market and get profit through speculation. Perhaps, you think that the TSLA stock has had a fantastic run and expect it to pull back a bit in the next month. Investors can use CFDs to short the stock and make money if their investment prediction materialises.
Short-term investments are generally not made based on the fundamentals of a business. Instead, they are meant to take advantage of short-term development in the stock price or an economic event.
You can find out more about CFD trading with our comprehensive online guide.
Options strategies
Options strategies are a somewhat more sophisticated tool to make money in the stock market. Some strategies can be used to hedge existing positions. Others, like writing covered calls or selling puts on a stock you want to buy, can generate income through premiums. Other options strategies are yet more complex and require some technical understanding.
Which companies are best for making money in stocks?
Picking the right companies is always challenging and much depends on the investor's chosen approach.
For dividend income, investors should look for high-quality businesses that generate stable and predictable cash flows. Ideally, these companies have a high market share, limited competition and are in an industry with high barriers to entry. Good dividend stocks tend to operate in mature industries. Some examples are Costco (COST), Walmart (WMT), Home Depot (HD), Abbvie (ABBV), Johnson & Johnson (JNJ), JP Morgan (JPM) and IBM (IBM).
Fundamentally, the value of a stock is determined by the company's earnings. High-quality companies that can grow profits at a high rate, without taking on debt, are the best candidates for long-term investments. Apple (AAPL), Microsoft (MSFT), Nike (NKE) and Disney (DIS) are a few examples. Investors can also consider leaders in industries that are expected to grow significantly in the upcoming decade. Artificial Intelligence, machine learning, robotics, data storage, renewable energy & energy efficiency, cybersecurity and biotech are some of those industries.
It's critical to draw a clear line between investments and speculation. Speculation and short-term trading should be used to bet on a particular event or an outcome. Investors should have clear exit strategies for their speculative bets. Best stocks for this type of investing are either smaller companies or companies that are highly leveraged to a particular business or a macro event. For example, for Tesla, vehicle deliveries can often significantly move the stock, while oil stocks tend to be highly leveraged to geopolitics. Investors can also speculate on a potential acquisition.
With all of these examples, traders can take advantage of short-term developments, but should not confuse speculative investments with long-term investments.
Major risks of investing in stocks
Investing in the stock market does present some risks. Shares are a junior piece of the capital structure. Shareholders are entitled to a percentage of the earnings but also are the last in line in case of a bankruptcy. Typically, in a liquidation, shareholders can recover very little of their investment. In that context, a recent rally in the shares of US companies that have declared bankruptcy is an example of a speculative bubble.
For long-term investors, assuming portfolio diversification, stocks represent a great risk-reward trade-off. In the short-term, however, stock market volatility can often lead to losses as, according to John Maynard Keynes, "markets can stay irrational longer than you can stay solvent." In 2020 alone, stocks experienced a sharp selloff followed by the biggest 50-day gain in history.
Investors should also be cautious with using leverage as it magnifies both gains and losses.
Read more: Long-term investments: how to build a winning portfolio
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