Published December 10th, 2018 by Philip Konchar
This article is a guest contribution from Phillip Konchar, and does not neccessarily reflect the opinions of Sure Dividend. Phillip is the Head Tutor at My Trading Skills. Over the past 10 years he has provided trading education and market analysis to a range of financial institutions.
Investing in stocks is one of the best financial decisions you can make, whether you’re a young investor or close to retirement. Naturally, the way you invest your money into the market and your allocation in stocks will vary depending on your investment goals and risk appetite.
Young investors may invest in more volatile and riskier stocks which have a greater rate of return in the long-term, while older investors may want to focus on preserving their wealth and capital at the first place by investing into less-risky stocks and allocating a portion of their capital into fixed-income bonds.
In any case, investors seek to make money by investing into assets that either create income, rise in value, or both. Consider gold investments, for example. If an investor believes that gold has the potential to rise in value in the coming years, he could allocate a portion of his investments into gold and enjoy its rise in value.
However, gold doesn’t create income besides its potential to rise in value. Stocks, on the other hand, are able to generate both capital gain by rising in value, and create income through dividend payouts. In this article, we’ll dig deeper into the best ways to earn from investing in stocks.
What are Stocks?
Let’s first explain what stocks actually are and why do companies issue them. Companies issue stocks to raise capital from investors. If a company needs to fund the research and development of new products, expand to foreign markets or hire additional stuff, it can do so by issuing new stocks to investors.
Watch: The Basics of Equities Explained
Investors who buy those stocks receive ownership rights in a company. That’s why stocks are also called equity investments. Nevertheless, many investors don’t buy stocks to receive ownership and voting rights, but rather to make a profit from capital gains and dividends.Once the company expands its business and increases its earnings, investors will reward the company with higher stock prices. This is called capital gain and is one of the ways how stock investors make money in the market.
The other way is dividends, which companies can either pay out to their investors or reinvest in their business. Dividends are simply a portion of the company’s profits which are distributed to the company’s owners, i.e. shareholders. In order to receive dividends, an investor needs to be the owner of the stock at its ex-dividend date.
There’s no hard rule on which stocks are better to buy – those which distribute dividends, or those which reinvest the profits into the company. When Microsoft (MSFT) went public, it decided to reinvest its profits which helped the company to become one of the largest tech giants in the world, which in turn increased the price of its stocks dramatically. Another example is Warren Buffet’s Berkshire Hathaway, which also doesn’t distribute dividends but invests the proceeds into new investments. Both companies’ stocks rose to breathtaking levels in the last few decades.
Pros and Cons of Investing in Stocks
While investing in stocks has many benefits, there also certain drawbacks which new investors need to consider carefully. One of the main advantages of buying stocks is their enormous growth potential. Since the 1920s, the US stock market has averaged around 10% of return per annum. Those are significant returns when you compare them to the average interest rates at commercial banks, for example.
Even financial crises haven’t managed to halt the growth of the stock market. The average duration of financial crises and recessions in the US – the largest stock market in the world – has been around 10 months. The following table shows all the US bear markets since World War II. Each time, investors had a great opportunity to buy stocks at a discount price and enjoy the consecutive capital gains.
Source: Seeking Alpha
If you’re holding stocks long enough, evidence shows that you’ll make a significant profit. The following chart shows the annual returns of S&P 500, sorted from the lowest to the highest. As you can see, the index has experienced positive returns most years.
Source: Waypoint Financial Planning
Stocks are also relatively cheap to buy compared to other types of investments, such as real estate. At the time of writing, you can buy a stock of Apple Inc. for about $170.
The main drawback of investing in stocks is their volatile nature. Prices can go up and down in a moment’s notice, and there is not much you can do about it in the short-term. That’s why a longer-term approach to stock investing usually returns the best results, as you won’t worry about short-term price fluctuations caused by events such as news or earnings reports.
Capital Gain, Dividends and Foreign Investments Explained
As the article title suggests, there are three main ways to make a profit from stock investments. We’ve already mentioned the first two – capital gains and dividends – which will be further explained by a few examples below. The third major way to profit from stocks is through foreign currency appreciation.
Capital Gains
If a stock’s price rises on the stock exchange, investors make an unrealized capital gain. Those gains will become realized once the investor decides to sell the investments and collect the profits. Let’s say an investor bought 1,000 stocks of company XY for a price of $50 per stock. After five years, the stock’s price rose to $120 and the investor decides to close his position and collect the profits. The total profit the investor made solely on capital gains would amount to $70,000 before taxes (1,000 stocks x $120 – 1,000 stocks x $50).
Dividends
The above example didn’t take dividends into account. If the same company XY distributes dividends on a yearly basis which amount to $2 per stock, our investor will make an additional $2,000 per year from dividend payouts. The investor can decide to reinvest those dividends into buying additional shares of company XY or he can put that money aside. Without reinvesting the dividends, the investor would additionally make $10,000 on top of the $70,000 profit over the five-year period.
Foreign Currency Appreciation
The third way to earn from investing in stocks is through foreign currency appreciation. However, this works only if you invest in foreign stock markets, such as emerging markets. Besides diversification that this approach carries, you can earn both from capital gains and the appreciation of the foreign currency. This might sound complicated at first, so let’s cover it with an example.
Consider the following situation. You decide to invest $20,000 into the German stock market by buying stocks of Volkswagen AG, which trade for 150 euros per share. If the current EUR/USD exchange rate is 1.33, you would be able to exchange your $20,000 into 15,000 euros and buy 100 shares of Volkswagen AG.
If the stock’s price rises to 200 euros after two years, and the EUR/USD exchange rate remains the same at 1.33, you would make a profit of 5,000 euros (100 shares x 50 euro of capital gain), which in US dollar terms would amount to $6,650 (5,000 euros x 1.33). However, if the euro appreciates against the US dollar to trade at $1.50, your profit in US dollars would rise to $7,500 (5,000 euros x 1.50). This way, you would make a profit both from capital gains and the higher EUR/USD exchange rate.
Bear in mind that investing in foreign markets can also decrease your profits if the foreign currency depreciates.
Picking Reliable Stocks for an Income-Oriented Portfolio
Investors and portfolio managers need to assess the financial stability and future growth potential of a company when creating an income-oriented portfolio. This is especially important for investors who are close to their retirement age and have the primary goal of preserving their capital while simultaneously allowing their stock investments to grow.
Larger companies with a high value of annual sales usually have an advantage over smaller companies in income-oriented portfolios, since they’re usually more stable and have a track-record of dividend payments and strong financial standing. Larger companies also carry a lower risk of bankruptcy compared to smaller and younger companies.
Another important consideration is the stock’s price. Overpaying a stock can reduce the growth potential of your income-oriented portfolio, so most investors use the Price to Earnings ratio to assess whether the current stock’s price is overvalued relative to the company’s earnings. One of the most popular investors, Benjamin Graham, listed the following criteria which a stock has to meet to be included in an income-oriented portfolio.
Company size – Larger companies are considered more stable than smaller companies. Graham states that the annual sales of a company have to be at least $500 million (in today’s money) to be considered for an income-oriented portfolio. Earnings history – Most investors avoid companies that have reported losses in the last few years. Graham states that a company has to report positive earnings in the last 10 years to become part of an income-oriented portfolio. Financial condition – A strong financial condition reduces the likelihood of bankruptcy. Look for companies that have a current ratio (total current assets / total current liabilities) of at least two. Overvalued stocks – Graham suggests avoiding overvalued stocks in an income-oriented portfolio. Look for stocks that have a Price to Earnings ratio lower than 15. Dividend payments – Companies that pay out dividends can increase the value of your investments and should be added to an income-based portfolio. According to Graham, look for companies that have paid out dividends for the last 20 years.Investing in Stock Funds
If you don’t want to create a portfolio of individual stocks, you can invest in stock funds and still get exposure to various industries and increase your diversification. Mutual funds have become very popular in the last few decades as they provide a simple way to own a professionally-managed portfolio of many stocks. Exchange-traded funds (ETFs) are another popular investment vehicle that includes a basket of assets and trades on an exchange just like individual stocks. Finally, index funds provide diversification with low fees by tracking a particular stock index, such as the S&P 500 or DJIA.
Increase Your “Time in the Market”
Time in the market refers to the total time that you’ve been holding your investments. In the stock market, a longer-term investment horizon typically returns better results than regularly buying and selling stocks. More time in the market equals to more opportunities for the prices to increase in value, as you’re less affected by the short-term market volatility. It also allows you to collect dividends for a longer period of time and reinvest those proceeds into new investments.
While the stock market has averaged around 10% of return in the last few decades, this doesn’t mean that every year has been profitable. Short-term investors may actually lose money by having a very short-term approach to stock trading. Market volatility, especially during the release of earnings reports, can easily eat up a large amount of profits of short-term investors. The compounding nature of holding your investments and reinvesting dividends will start to pay off over five, 10, 20 or even more years of being invested in the market.
The following chart made by Business Insider captures the S&P 500 returns based on the time horizon. During a one year holding period, short-term market volatility can create either a huge profit or loss. As the time horizon lengthens, the negative annualized total return shrinks to only 3.1% over 20 years.
Source: Charles Schwab
“The real money in investing will have to be made – as most of it has been in the past – not out of buying and selling, but out of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value.”
– Benjamin Graham
Conclusion
Investing in the stock market is a great way to earn both from the increase in the stocks’ value and from dividend income. In the last few decades, the stock market has averaged annual returns of around 10% which beats many other types of investments. Even financial crises haven’t impacted the performance of the stock market to a large extent when using a long-term view – the average financial crisis in the US lasted for only 10 months and revealed a great opportunity to buy additional stocks at a discount price.
If you’re investing in foreign markets, bear in mind that exchange rate fluctuations of the foreign currency can work both for and against you. Try to invest in markets in which the foreign currency has the potential to appreciate against your domestic currency over the holding period.
A longer-term approach to stock investing has shown to have better results compared to buying and selling stocks on a regular basis. The compounding effect of increasing prices and dividend reinvestments can significantly boost your trading performance over the long run. If you’re an income-oriented investor focused on preserving your investment capital, Graham’s criteria for picking reliable stocks can help you to create a high-quality income-oriented portfolio that has a high income potential during your retirement years.