Maybe you’ve heard stock investing is a good way to generate passive income and wonder what it would be like. Stock investing, done right, is certainly a great way to build wealth and generate income. Done wrong it can cost you a lot of money and waste a lot of time.
In this article we’ll talk about the experience of stock investing. We’ll talk about the right way and the wrong way to use stocks, including understanding the risks involved and how to reduce those risks.
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What are stocks?
When a company wants to raise money to build buildings, buy equipment, hire initial workers, and pay for everything else needed, they typically sell stock in the company. Stock is ownership in the company where each share represents a small portion of the company. Your portion of the company is equal to the number of shares you own divided by the number of shares issued. For example, if you own 200 shares and there are 10,000 shares outstanding, you would own 2% of the company. You would then be entitled to 2% of any profits generated and distributed, 2% of the sale value of the company if it is sold, and 2% of any break-up value of the company if they decided to close and sell everything off. This last event basically never happens unless the company declares bankruptcy, and then most of the assets will be taken by creditors to pay bills, so you’ll probably get nothing.
The direction of the company is decided through shareholder votes with each share allowing one vote. If you own more than 50% of the shares, you effectively own the company since you can the outvote anyone else. A board of directors mostly controls what votes occur, but there is a process where any shareholder can get items on the ballot for all shareholders to vote on.
There are two reasons to buy a stock. The first is that most companies will pay out a portion of their profits once they become profitable enough to do so. The percentage paid is typically pretty small (often 1% or less), but with time the amount they pay will grow if the company continues to make higher profits and grow. So, maybe you invest $1000 in a company and they pay a 1% dividend, or $10 per year. But as you hold onto the shares for several years, they could keep growing and making higher profits. Your $1000 position could then become worth $10,000. Even if they keep paying a 1% dividend, you’ll now get $1000 per year. You are now making a 100% dividend on your original investment!
The second reason to invest is that as companies get higher profits and pay out higher dividends (or have the potential to do so), your investment will be worth more. You can then sell your shares for a capital gain. You can also just continue to hold onto the shares and let your position continue to compound and grow. It is rare, but it is possible over a 20 to 30-year period to see a position grow from $1000 to a million. Here you would need to be lucky enough to buy into a company like Microsoft, Apple, or Home Depot early that grows and becomes a huge company.
How risky is stock investing?
Investing is not like putting your money in the bank and getting interest payments. Even if you buy a company that pays a 2% dividend, say, it does not mean that you will keep receiving 2% forever. The dividend needs to be voted on every year and can be cut if business turns bad and they aren’t making enough money to keep paying it. A stock will go up in price if the company does well and grows, but it will not move anywhere or even drop in price if they don’t grow. (Note that it is the growth in profits that causes a stock price to go up, not the amount of money they are making or the volume of products they are selling.)
Investing allows for higher returns than simply saving your money in the bank because there is risk involved. When things work out and the company becomes profitable, the returns you’ll get will be enough to make up for the risk that you took. If you buy several companies, the amount you lose on those that don’t work out will be more than covered by the profits on those that do well. If you buy a lot of stocks (hundreds) in companies doing different things (banks, tech companies, service companies, etc…) returns historically have been around 10% (7% after inflation). This is well above the rates you’ll receive from banks which are usually just below the rate of inflation.
If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)
If you were to buy a stock at random in the markets, your chances of it growing and doing really well are around 5% in my experience. This means about 1 in 20 companies will grow 1000% or more over a period of 10 to 15 years. Likewise, about 5%, or 1 in 20, will go bankrupt and become worthless. This means you’ll lose all of your investment about 5% of the time. All other stocks will be somewhere in the middle with the average stock in this group returning the equivalent of maybe 4-8% per year, but with many having negative returns.
Returns will also not tend to be steady. Instead, a stock may shoot up and double in price within a few weeks or a few months, but then fall back and lose 50% of it’s value in a period of a few weeks or even days. (Stocks go down a lot faster than they go up most of the time.) So, a $5000 position could easily become worth $10,000 in a few weeks, but it could also become worth $2000 just as fast or faster. When things go badly, a single stock could easily lose 90% and then slowly decay to $0 over the next year or so.
Reducing risk
There are two main ways of reducing risk when investing in stocks. The first is to buy several different companies instead of buying just one or two companies. While single stocks move very quickly up or down, when you buy a lot of different companies, you’ll have ones that are going up when others are going down. This means that instead of seeing movements of +100%/-50% in a few weeks or days, you’ll see movements of +/- 20%. During a really bad market (called a bear market) you could see declines of 30-40%, but these are fairly rare. If you just hold on and wait a while after these kinds of events, your portfolio will recover and then advance. As stated above, average returns of 10% annualized over long periods of time (10-20 years) have been received in the past, meaning that it would be like having a bank account that paid 10% per year. Of course, the returns during any 10-year period vary, but almost all have at least been positive. Some have been much higher than 10%.
The second way to reduce risk is to hold onto stocks for long periods of time. No one knows when stocks will move up or move down, but history has shown that they tend to go up over long periods of time, so if you just buy a lot of different stocks and then hold on for years, you are very likely to have positive returns. Hold on for 15 to 20 years and chances are good that your returns will be around 10% annualized, or 7% after inflation. This could change, but it has been true for most 15-year periods over the last 120 years or so since we’ve had public stock markets.
Note that this requires that you buy and hold through all periods. If you sell during a bear market and then try to buy back in, you can miss a big move up, reducing your returns substantially. Stock market rallies tend to be fast and short. If you miss a few good days, instead of getting 10% returns, you might get 4% returns.
Mutual funds and ETFs
The easiest way to buy a lot of different stocks is to buy mutual funds. This is where you send money to a fund company. They hire a manager who takes your money, along with that from many other investors, and invests it for you. He buys a large number of different stocks, then you have ownership in a share of the portfolio. You will receive a portion of the dividends companies in the portfolio receive, plus you will be able to sell your shares in the mutual fund at a higher price than you paid if the portfolio does well and the stocks in the portfolio go up in price.
With a mutual fund, you can send in $5000 and have ownership in 100 different companies. Buying shares in all of those companies on your own would require you have $250,000 or more to invest because the cost of buying shares in all of those different companies would be so high. There are several different fund companies, Vanguard and Fidelity being well-known ones.
Exchange Traded Funds, or ETFs are mutual funds that you can buy on the stock market the same way you would buy a stock. There are advantages to doing this, including that costs tend to be lower than they are for traditional mutual funds. They also allow you to buy mutual funds in a regular brokerage account rather than needing to go through a mutual fund company.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing..
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