I always knew that investing in a retirement plan was important. My dad drilled that into me when I got my first job stacking books in a college library. It wasn’t till later though that I realized I could invest in stocks on my own and that it’s kind of addictive. I love watching my investments grow and I’m always asked how investing in stocks actually makes me money. In reality, it’s pretty simple!
There are three ways that investing in stocks makes an investor money. The first is capital gains which are the profits from selling a stock at a higher price than when it was bought. Second, is dividends which are small payments from a stock company to its investors as a way of sharing in the company’s profits. Lastly is time, which allows investments to grow at compounded rates.
Let’s cover each of these with a little more detail so you can better understand how stocks actually make you money.
How Do Capital Gains Work?
Capital Gains are the profit received from selling your shares of stock. If you sell the stock for a higher price than you purchased, you are receiving capital gains.
If my name was Luke and I bought 100 shares of company that sells moisture evaporators for $10/share, I would have spent $1000. If the stock increased in value to $20/share because of an increased demand of moisture farms, I’d have $1000 in capital gains. ($20/share x 100 = $2000. $2000 – initial investment $1000 = $1000).
If you haven’t sold the shares, you would have “unrealized gains” which means that although they have increased in value, you haven’t actually sold them to profit.
Understanding unrealized gains vs realized gains is more important when you are considering tax implications.
Let’s see an example from one of my investments:
I bought 10 shares of Workday (WDAY) in October 2018 for 1453.25 and sold them 1/3/20 for 1671.27. My capital gains from this investment were $218.02. That means I made a 15% return on my capital investment.
How Do Dividends Work?
A dividend is a share of the profits from a company to its shareholders. If a company wants to reward investors for their faith in their company, they can pay out a dividend.
Usually dividends are paid out quarterly. Some companies pay dividends semi-annually.
What makes dividends great is that you can receive profits from your investment without selling your investment. If you own stock for 10 years and it pays a dividend, you could have a quarterly check every quarter and all of your shares will still be invested in the company.
Take Luke for example. Let’s say it paid a dividend of $0.50 per share. That means that when Luke bought his 100 shares for $10, his dividend yield would be 5% ($0.50/$10). When the stock hit $20 per share, if the company still paid a 5% dividend, it would be $1/share ($1/$20) but the added benefit to Luke is that his yield is based on his purchase price so that $1/share dividend is actually now a 10% yield ($1/$10).
Finding stocks that pay consistent and increasing dividends can be a valuable model. In fact there’s a term for those companies which is known as Dividend Aristocrats. Dividend Aristocrats are companies that have increased their dividend every year for at least of the previous years.
Do Companies that Pay Dividends Still Generate Capital Gains?
Increasing a company’s stock value is always strived for. Companies want their stock to go up because that means their company is successful and perceived as successful in the Stock Market. Finding companies that are rising in value each year and consistently paying dividends is a great way to invest.
Take Coca-Cola for example. They are a Dividend Aristocrat and have been increasing their dividend yield for the last 58 years.
Their stock has also increased quite a bit in that span as well. Below, is their performance since 1973. I wish I had invested in Coca Cola back then…oh yeah, I wasn’t born yet…
That being said, not everyone cares about rising individual stock prices. Some investors choose to find high dividend stocks and disregard the value of the stock price because they are only concerned with the quarterly payouts rather than the equity built by holding it over time. Everyone’s investment strategy is their own.
How Does Compound Interest Work?
“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”Albert Einstein
The amazing thing about compound interest is that small consistent gains lead to large gains through the passing of time. This is what makes the Stock Market so awesome.
If you were to have $100 and invest it at 10% interest/yr, you will have a total of $110 at the end of that year. The next year, you will earn 10% on $110 and so on. If you leave that $100 for 25 years, it will amount to $1083.47.
Now, imagine if you made $100 contributions each month for that 25 years. $100 x 12 months x 25 years will mean you invested $30,100. After that 25 years though, it will amount to $119,099.94. Not too shabby…
Every year you allow your investment to compound will lead to more and more gains on your investments.
How Do You Make Money Investing In Stocks?
In order to start making money in stocks, first decide what types of stocks you want to invest in based on your investment objective. For some, receiving regular income each year is important while for others, amassing wealth for retirement is the goal.
Stocks that pay dividends are considered Income Stocks or Fixed-Income stocks whereas those that increase in value at above average rates are considered Growth Stocks.
Generally Growth Stocks do not pay dividends because they aggressively invest all of their earnings back into the company rather than distribute earnings amongst shareholders.
If you want dependable and consistent income each quarter, dividend stocks are going to be a good fit. See whether or not you should invest in dividend stocks for more information.
If you like investing in new tech or rapidly growing companies, you may fancy growth stocks. If a stock is new to the stock exchange, you’ll probably see news about its IPO (Initial Public Offering). If a stock has an IPO, its new to the Stock Market so it trying to gather major funding to help it grow which makes it a Growth Stock.
There are benefits to both and you could actually choose a mix of the different types. This is a smart strategy because it helps you diversify your investment portfolio. For example, choose five dividend stocks such as Coca Cola (COKE) and Lowes (LOW) and five growth stocks such as Tesla (TSLA) and Nividia (NVDA).
Fundamental vs Technical Analysis
There are a couple ways to find stocks to invest in.
You can choose stocks that are undervalued by analyzing their fundamentals such as income statements, cash flow statements and balance sheets. This is known as Value Investing. Fundamental Analysis does not pay any attention to stock charts and focuses on the companies financial documents exclusively.
You can choose stocks based on trading volume and momentum patterns. This is generally known as Technical Analysis and focuses on only charts and pays no attention to financial documents or the news. Often stock trading is confused with investing.
The main difference between investing and trading usually refers to timeframe. Traders are often trying to make quick gains over a lot of transactions whereas investors try to grow wealth over the long term.
Both methods require different skill sets that can be learned if you take the time. If you’d rather invest more passively without having to learn how to analyze individual stocks, you could invest in index funds, mutual funds, or join a Robo-Advisory service such as Acorns or Betterment.
Investing with an Investment Advisor or Investment Service
Robo-Advisors like Acorns, Betterment, and M1 Finance offer you the ability to choose portfolios based on risk tolerance, investment goals, and investment strategy. Both of these Robo-Advisors offer similar financial services and can be as hands-on or hands-off as you like.
I don’t have time to analyze stocks all day so I like investing in passive services like these to help me get the financial results I want with compounding returns over time rather than try to time the market.
You could also hire a Financial Advisor to help you manage your finances but these generally require hefty commissions that eat into your profits.
Investment services such as Motley Fool also are effective since they do the heavy lifting as far as research and recommend stocks that meet their criteria.?
In our review of Motley Fool, you’ll see that they have a long history of outperforming the market. In fact some of the Motley Fool picks in my portfolio are up over 100% in one year and 300% in the last 4 years.
How To Get Started
It’s pretty easy to get started. In fact, all you need to do is decide on what money you want to invest, choose and fund a brokerage account that fits your investing style, select stocks and purchase them from the stock exchange. The stock market doesn’t have to be scary.
I wrote a simple step by step guide for you if you want help investing in stock for the first time. Well, what are you waiting for? Let’s start investing!