How you’re told it works
You always hear in the media about people playing the stock market. You hear about people making it big by buying and selling at the right time. You also hear about day trading where people are trying to make money on the price difference of a few cents during the day. But is this really how true wealth is made in the stock market? No. It’s not. Actually a big NO. Sometimes it works out, but more often than not this is how people lose a lot of money in the market. It’s also why people think the stock market is just one big casino.
How it really works
You make money in the stock market from 2 things: appreciation and dividends. You make money because the stock price goes up and because companies pay dividends to their shareholders. How is that different than what I said before? Well, it’s in how you pick your stocks and what you do with them once you have them. I don’t actually like that term. I should say, it’s how you choose your investments.
Even though you can make money in the stock market by buying a stock and selling it when it goes up, true wealth is made when you buy a strong company that grows. Strong companies make more money than they spend. Since they make more money than they spend they can send some of that back to the stock holders. That’s one way you make money. The second is that since they make more money than they spend they can spend money on growing the company. This means that their profits will grow over time, the company will be more valuable and the stock price will go up.
How do you make that work for you?
The short answer is to buy a strong company when the stock price is currently less than what the company is truly worth. Ideally you read the company’s financial statements to find a company that is solid. Then wait for the price to dip. Buy the stock and hold onto it forever. This can work well with companies like Johnson & Johnson, Coca-Cola, and Exxon. The companies prices go up and down all the time, but the companies keep making money. Check out my post on Hubpages called Shortcuts to Finding Great Companies to Invest In. In it I talk about a few strategies to help save time for finding companies to invest in.
In that article I have three basic steps.
Step 1 Buy blue chip stocks.
These are companies that have been making essential products for years. Generally decades and sometimes a century or more. I recommend using the dividend aristocrats as a starting place for a list of stocks that meet this step. Another good source is Dave Fish’s US Dividend Champions spreadsheet. It’s available at dripinvesting.org. This is a list of all the US companies that have been raising their dividends for at least 25 years.
Step 2 Buy companies that are paying their owners.
Stick with companies that are paying a dividend. And not just any dividend. Stick with companies that are paying a dividend in the 3% or more range and that have been increasing their dividend for at least 25 years. I also recommend making sure that they have been increasing it every year by more than inflation.
Step 3 Buy it on sale.
Buy the stocks when they are valued less than they are typically priced or worth. One method is to buy when their PE ratio dips. I like to watch for stocks to dip below their historic median PE ratio. You could also use the Gordon discount model to buy when the price is less than the price the formula indicates. A third option is to buy when the market capitalization is less than the value of the company’s assets.
These types of strategies help people make true wealth in the market. While you can buy a stock and get lucky in that it’ll shoot up one day, if you follow these steps you can more reliably create true lasting wealth in the stock market. A good resource is Benjamin Grahams – The Intelligent Investor. I recommend anyone that wants to buy individual stocks read this book at least once. The book is about different strategies to value a company and find a company that has a stock price that is less than the value of what the company physically owns. The concepts extend beyond that though, and can be used to find companies that are selling at a discount.