Updated: Jan 26
Stock Markets have been creating wealth for investors for more than a century. $10,000 invested in the stock market 50-years ago could have resulted in a portfolio worth hundreds of thousands if not millions today.
On average, stocks have returned 10.5% per year between 1957 and 2021, although capital appreciation can greatly vary depending on the company.
This 10.5% percent per year are called CAGR (Compound Annual Growth Rate) ,
Let's take the simplest possible example.
Below, is the chart of the S&P500 index fund, and the highlighted are starts in 1972, i.e. 50 years ago.
The price at that time was ~$100, while the price today is ~$4,700. Simple math shows that an initial investment of $10,000 back in 1972 would be worth ~$470,000. (the numbers are not inflation adjusted, for any economist among us)
You are right, 50 years is a lot of time. However, keep in mind that those money worked for themselves without requiring any action from your side.
Also, notice that half of the money were made in the last 5 years. This is a phenomenon called compounded interest. As Albert Einstein said:
“Compound interest is the 8th wonder of the world”
You can find more about it in the nice video below, which explains why 10 + 10 = 21:
Although investing in the stock market has been one of the most effective ways to build wealth over time, there are more approaches about it. Broadly speaking, there are two strategies that investors can use to make money in the market.
And that's this article about, so let's go! 🚗
Buy and Hold
The Buy and Hold strategy has historically resulted in exponential growth of invested capital. Investors who employ this strategy tend to make money in two ways, including Capital Appreciation and Dividends.
Capital Appreciation is the difference between the market price of a particular stock/mutual fund and the cost of purchase. Capital Appreciation is not taxed until the trade is realized (closed), at which point it is referred to as Capital Gains.
So how this works?! 🤔
For instance, if an investor were to buy Tesla stock today at $1,050 per share, and the price rises to $1,250 in a year, the capital appreciation is $200 per share. This $200 would be considered as capital gains if an investor decided to sell his/her position and book the profit.
For reference, you can see the Tesla stock price evolution since going public (just because it is one of my favorite stocks):
Investors are taxed on capital gains in two different slabs based on the duration, including short-term capital gains (stock bought and sold in less than a year) and long-term capital gains (stock bought and sold is longer than one year).
Several factors can lead to capital appreciation in stocks/mutual funds, including an improvement in the fundamental performance of the underlying company/sector, demand, and supply for the security.
In general, stocks tend to trade at multiples of their earnings, and a rise in earnings can lead to the price of the stock rising. That is basically another story, but you can read here what is the famous P/E Ratio (Price to Earnings Ratio).
Beside the difference between the buy and sell price, there is one more way of making money by holding your stock - DIVIDENDS
As mentioned, Dividends is another key way shareholders are rewarded for buying and holding stocks.
Dividends are periodic cash payments, that are distributed by companies to shareholders. When a company generates profit, it pays out a percentage of these profits as dividends to shareholders, while the remaining is kept with the company as retained earnings.
For a company to pay out the dividend, it needs to be approved by the shareholders of the company. In addition to recurring dividends, companies also make special dividends in certain cases, such as the sale of a subsidiary.
I understand if you have the impression that dividends are old fashioned, however, they can play a crucial role in your passive income stream during the periods of market downturn. Further move they can be re-invested so that they generate additional income. That may sum up to significant numbers.
Still skeptical?! Look at the example below. 🤓
One of high dividend payers is Enviva (EVA), which is paying at the moment some nice 4.6%.
I would like to show you below two charts, first is a portfolio holding EVA, and relies solely on the price evolution, i.e. no dividends. The second chart is also a portfolio holding EVA, but it re-invests all the dividends paid.
Yes, you have seen it right! There is a $22,000 difference! I could have not believed my eyes too! 😨
You may be wondering why some companies pay dividends, while others don't.
As a rule of thumb, large, established companies with predictable earnings such as Banks, Oil & Gas, and Utilities tend to pay the highest dividends, as they want to maximize shareholder wealth in addition to the normal growth seen from the business.
The average return from dividends has been between 1-2%, although established companies can pay dividends as high as 7-8%.
If you are interested, I have a different article where I have a 3 dividend stocks pick which also keep one's portfolio diversified. In short, they are EPD, MMM and WBA. If you would like to see the full thesis, you can read it here.
I invite you to also explore our dedicated section on dividend stocks - Dividend Stars
Hope you did not get bored until here.
If so, prepare to wake up, as we are going to describe next the different ways in investor can further improve their gains.
Gain Amplifiers 🚀
In contrast to the buy and hold strategy, investors can make money by trading equities using leverage and other instruments such as futures & options.
Investors can leverage their portfolios to substantially increase the returns on their trades.
When investors use leverage, they are essentially borrowing money to increase the gains on invested capital. These gains are a result of the difference between the investment returns from the borrowed money and the cost of borrowing the money (in this case interest).
While using leverage results in a significantly higher gain, it will also expose investors to higher risk. The different types of leverage employed by investors include Margin Loans, and Stock Futures & Options.
A margin loan lets investors borrow money against existing shares & cash in their portfolio to invest in other stocks.
For instance, a 5x leverage implies that investors can buy $100 worth of equities for every $20 of cash held in their portfolio. As a result, for every $1 increase in the stock price, an investor sees a $5 gain in the stock.
In investing terms, investing $20 with x5 leverage gives you a $100 exposure.
While Buying on margin is a great way to improve the return on investment, it can also lead to higher financial risk through a margin call and high-interest payments on the margin loan.
In other words, this is simply because the 5x multiplication of gains, can also be a 5x multiplication of losses. Furthermore, holding the position and waiting until it turns green makes you regularly pay the interest on the money loaned.
Here is an example of how it looks like to setup a leveraged trade on Etoro:
The three red arrows show the Leverage coefficient, the total exposure and the associated overnight fees.
My last word on margin loans is that you should use it very careful. The sweet taste of high potential gains can easily turn into nasty losses!
Futures & Options
Futures are contracts to buy or sell a specified quantity of underlying stocks at a later date for a price agreed upon.
An investor can look to buy/sell futures if they believe that the price of a stock in the future is higher/lower to earn a risk-less profit. Similar to a margin loan, futures also provide investors with the opportunity to borrow money against their portfolios to improve gains.
However, the potential downside risk with a futures contract is very large and is many times that of the initial investment. This is where Options come in as a great alternative to Futures, to potentially limit the downside and risk.
Options give the contract holder the right and not the obligation to buy/sell the underlying share, which is in contrast to futures where both parties of the contract are obliged to buy/sell the stock.
Although options are often seen as speculation instruments, they play a very important role in the economy, as they help companies to easier "freeze" the acquisition prices of the raw material they need for the next year.
For instance, it is much easier to arrange your cloth manufacturing business if you know in advance which will be the price of the wool you will have to pay next year.
About this and much more, you can find the awesome book called "A Random Walk Down Wall Street", which I strongly recommend you to read.
Now let's move to a very interesting and controversial technique - SHORTING
Shorting a Stock
Referred also as Short Selling, this is a popular investment technique used by Hedge Funds & Traders to sell shares that the seller does not own.
Investors who short a stock believe that the stock price is going to be lower in the future. As a result, they would sell the stock today by borrowing it from brokers, to buy it back at a lower price shortly.
If the price of the stock falls in the future, an investor will make gains by pocketing the difference between the price at which a stock is sold and when it is bought.
For instance, if an investor thinks that Apple stock is overvalued at $175 today, they can borrow 10 shares and sell them at $1,750. If the stock then drops down to $150 soon, the investor will buy back 10 shares at $1,500, resulting in a profit of $250.
Here is how such a trade would look on Etoro:
Note that this time the "SELL" button is active and the trade is called "SELL AAPL", as indicated by the red arrows.
While shorting a stock can result in large gains, it also results in significant risk if the price of the stock moves up. Shorting also has high costs associated, as the broker charges interest on shares borrowed. As indicated at the bottom of the picture above, there are also some small fees associated with the trade
Selling Short vs Closing a position - Important tip for beginners
While scrolling through the Post Feed on Etoro, I saw many times investors who opened a SELL Trade and asking why their position goes red as the stock price rises, if they simply wanted to close a BUY Trade.
So, in order to close an existing BUY Trade, you need to go to your portfolio and click the red cross on the right. A new dialog window appears where you shall click the "Close Trade" button.
That will close you existing position and you will book the existing gains of losses. Here is how it looks like:
That's mainly it from my side on this subject.
I wish you all good profits, regardless of the technique which you decide to apply
Hope this was useful for you! Please note that the above content is not an investment advise and shall be considered only for informative purpose.
Feel free to share you comments below.