Investing can be somewhat intimidating to the person who only knows that their money is safe in a bank and only recalls the fears of the sensationalism the media makes during any recession. It goes against the very nature of the working class mentality of working harder to earn more. However, with a little education regarding stocks and how they work, lowering your expectations of “getting rich quick”, and providing yourself with a cushion such as maintaining a diversified portfolio, you may find that stocks are the perfect vehicle to allow your hard earned money to start making more money for you as opposed to sitting in your bank account waiting to be spent.
Savings Account vs. Investment Portfolio
A savings account is exactly like your piggy bank at home with the exception of maybe a 1% annual interest rate. The money you put into it won’t be taxed again until you buy something that is taxable with it. Though there is nothing wrong with a savings account, and in all respects you should have at least a third of all your wealth in one, you cannot expect to get a lot more money out of it than what you decided to place into it. Even with $10,000 in an account, you could only expect to see a return of $100 at the end of the year, and that’s assuming you were a good boy or girl and didn’t touch it for the year.
On the other hand, investments can be paralleled to miniature properties. The money you put into a stock becomes valued. Value can go up, and it can go down… and that volatility is what people fear. One thing to understand about stocks is that, just like property, you don’t lose money unless you sell it for cheaper than you bought it or you somehow lose the property, where in the case of stocks a company shutting its doors for good would be an example of losing your property. There are many forms of investing but our focus is on stocks, and keeping in line with real estate it’s very easy to show you two basic ways you can get a return on your investment (ROI). These two methods are “collecting your rent” with dividends, or “flipping the house” by buying the stock cheap and selling it when it’s high.
“Collecting Your Rent” with Dividends
These stocks are perfect for those looking to risk a little less but seeking a good ROI. Dividends are a percentage of the profits that the company pays out for each stock owned. These are usually fixed or variable and can pay quarterly or annually. Just like collecting rent, you receive a small portion for each stock owned, and if you own a considerable amount you will notice a very handsome ROI. Using the same $10,000 example from the savings account, if you own a stock that cost you only one dollar per share and received 2% (2 cents) for each share with a fixed dividend payout ratio quarterly, then you would receive $200 every three months! Still assuming you are a good boy or girl, that’s $800 by the end of the year that you didn’t have to spend too much time or effort trying to earn.
Companies that usually offer dividends tend to have matured in their field and their stock prices don’t have the tendency to fluctuate as much as they have attained stable or steadily growing income. Since one can not expect to make much of an ROI by buying the stock cheap and selling it high, the companies offer dividends as an incentive to invest in them. However, beware of companies offering a high dividend if they show poor profitability. Some failing companies offer a high dividend in order to gain capital from investors to try and stay afloat. So the same way you’d do a credit check for a potential tenant for your apartment, make sure you do that background check for a potential stock purchase to make sure they can pay you.
If over the course of time a person were to invest $300,000 into stocks that yield an average of at least 2%, they could comfortably live off of the earnings of $60,000 per year, making this the perfect method of investing for those looking for a steady supply of income from their money.
“Flipping The House” with Growth Stocks or Speculative Stocks
Basic math: if you buy something cheap and you sell it for more money, you will end up with more money. This is the simple premise behind the “get rich quick” method of buying and selling stocks. Though it can work, the same problem arises as when you buy a house… there’s no guarantee that you’ll get more than you bought it for when you’re ready to sell. However, with higher risk can come greater reward and if you purchased a stock for $200 which overnight jumped in value to $600, selling it would triple your investment in a heartbeat. Yet the volatility in these stocks is such that you decided to hold on to it for one more day and the value dropped to just $125.
Growth stocks and speculative stocks are so closely knit as growth stocks are those showing a strong earnings per share growth rate, and are generally on a pattern to continue a high amount of growth within a relatively short amount of time. Google stock is a current example of a growth stock, however this stock is also prone to speculation. If the company announces it is coming out with a new product, speculation on the consumer demand for this product may drive the stock price up quickly, though the reality of the poor success of the product may drive investors to sell their shares and leave you with stocks much lower in value than what you purchased them for.
The other danger of reaching for a growth stock is if it begins to mature before you sell it. Maturation of a company can be observed by a steady decline of its growth rate. Though this may lead it into eventually offering dividends, this may not be an enticing prospect for you as an investor if you purchased the stock at its top value.
Pros and Cons Facing Both Methods
The obvious positive aspect of investing in stocks is the ability to earn money. One mathematic principle that investors rely heavily on is the concept of compounding interest. Dividends can be used to take advantage of this concept by the utilization of Dividend Reinvestment Programs (DRIPs), and growth stocks can be taken advantage of by buying low, selling high, than doubling your original investment (or as much as you can without losing all your profit) and repeating the process. Though it can seem complicated, the math here is simple if you make everything $1. If you originally invest in a stock that costs $1 and enroll in a DRIP that offers a $1 dividend (won’t happen, and if it does don’t tell anyone), then on the first payment you will now own 2 shares of stock. On the second payment each stock pays $1, so you will now receive $2 giving you 4 shares of stock. If everything remains consistent, this pattern will continue and your earnings will exponentially increase. ($1=$2=$4=$8…)
The problem with investing at all is the risk based on not being able to predict the future. Just like looking at a student’s report card, a history of getting straight A’s does not necessitate that the student will continue to do so or even stay in school. It is likely, however, that they will continue as such if all the variables remain the same such as their funding for school, their health, and their study habits. The same goes for any such company, and in this world the only assured consistency is that variables are always changing so you must put in your due diligence and make smart decisions about the futures of the stocks you invest in based upon the variables that surround them as opposed to taking a gamble and praying for the best.
Another “problem” with investing is the amount taxed on each investment. Remember that these are little properties that you are buying, and when you sell them you have to pay a tax on that income whether you gained a profit or not. Taxes are different dependent on the country you are selling stock in, but most countries “double tax” investments by taxing the companies and then taxing the individual investor. Be sure to consider the tax regulations when deciding when would be a good time to sell your stocks and still come out with a decent profit.
If you have yet to invest due to fear or whatever the case may be, decide where you lie on the risk table. Are you looking for supplemental income or are you looking for a high return in a short amount of time? Once you decide this, figure out how much money you are willing to lose. As funny as that may sound, the worst thing you could do is be emotionally and financially dependent on the money you invest. At most, it should be a third of your total income, with another third in savings because nothing beats actual cash and a safety net, and the final third being used for your expenses. At its worst, a loss of this investment should make you feel glad you didn’t quit your day job.
The final thing to determine is what investment vehicle you will utilize. Are you more comfortable speaking with a knowledgeable broker face to face, or are you the type that likes the convenience of handling everything yourself and using your computer or smartphone to make trades? In either case, educate yourself and keep yourself in the know when it comes to your stocks. Two highly reputable online brokerages are etrade.com and tdameritrade.com, and they provide plenty of educational material for the amateur investor.
There are many means of making money in the stock market, including taking advantage of things like stock splits and short sales, but for now you know enough to get started and to test the waters of allowing your money to work for you.