Investing is one of the best ways to build wealth over your lifetime, and it requires less effort than you might think.
Making money from stocks doesn't mean trading often, being glued to a computer screen, or spending your days obsessing about stock prices. The real money in investing is generally made not from buying and selling but from three things:
- Owning and holding securities
- Receiving interest and dividends
- Benefiting from stocks' long-term increase in value
How to Make Money in the Stock Market
The best way to make money in the stock market isn't with frequent buying and selling, but with a strategy known as "buying and holding." This strategy was popularized by the father of value investing, Benjamin Graham, and is used by high-profile, successful investors like Warren Buffett.
As an investor in common stocks, you need to focus on total return and make a decision to invest for the long-term. This means that you:
- Select well-run companies with strong finances and a history of shareholder-friendly management practices
- Hold each new position for a minimum of five years
If you have chosen strong, well-run companies, the value of your stock will increase over time. As an example, you can view four popular stocks below to see how their prices increased over five years.
Successful Buying and Holding
High-profile investors like Warren Buffett and Charlie Munger have held onto stocks and businesses for decades to make the bulk of their money. Other everyday investors have followed in their footsteps, taking small amounts of money and investing it long-term to amass tremendous wealth.
For example, retired IRS agent Anne Scheiber built her $22 million portfolio by investing $5,000 over 50 years, and retired secretary Grace Groner built her $7 million stock portfolio with just three $60 shares in 1935.
The stock market is unpredictable, and constantly buying and selling in order to "beat" the market rarely works in the long-term. Instead, you are more likely to be a successful investor if you choose valuable stocks and hold onto them for years.
How Stocks Work
Before you can make money from the stock market, it's important to understand how owning stocks works. This will allow you to make smart decisions about where to invest your money.
When you buy a share of stock, you are purchasing ownership in a company.
Harrison Fudge Company, a fictional business, has sales of $10 million and a net income of $1 million. To raise money for expansion, the company's founders approached an investment bank and had it sell stock to the public in an initial public offering (IPO). The underwriters create 440,000 shares and sell them for $25 each. In this scenario:
- Each share of stock in Harrison Fudge is allocated $2.72 of the company's profit ($1 million profit divided by 440,000 shares). This figure is known as the earnings per share (EPS).
- If you acquired 100 shares for $2,500, you would be buying $272 in annual profit plus whatever future growth (or losses) the company generated.
If the management team increases can increase sales by five times in the next few years, your share of profits could also be five times higher, making Harrison Fudge Company a valuable long-term investment.
When you own stock in a company, however, you don't immediately see the per-share profits that belong to you. Instead, management and the board of directors have options for what to do with those profits, and their choice will impact your holdings.
- The company can send you a cash dividend for some or the entirety of your profit. You could either use this cash to buy more shares or spend it any way you see fit.
- The firm can repurchase its shares on the open market and keep them in-house.
- It can reinvest the funds generated from selling stock into future growth by building more factories and stores, hiring more employees, increasing advertising, or any number of additional capital expenditures that are expected to increase profits.
- The company can strengthen its balance sheet by reducing debt or by building up liquid assets.
What Strategy Is Best for You?
Which strategy is best for you as an owner depends entirely on the rate of return management can earn by reinvesting your money. Sometimes, paying out cash dividends is a mistake because those funds could be reinvested into the company and contribute to a higher growth rate, which would increase the value of your stock.
Other times, the company is an old, established brand that can continue to grow without significant reinvestment in expansion. In these cases, the company is more likely to use its profit to pay dividends to shareholders.
Valuable investments can choose any of these paths. Berkshire Hathaway, for example, pays out no cash dividends, while U.S. Bancorp has resolved to return more than 80% of capital to shareholders in the form of dividends and stock buybacks each year. Despite these differences, they both have the potential to be attractive holdings at the right price.
The best way to determine whether a stock is a good investment is to look at the company's asset placement and understand how it manages its money.
Building Wealth by Investing in Stock
When you understand more about how stocks work, it's easier to understand that your wealth is built primarily from:
- An increase in share price: Over the long-term, this is the result of the market valuing the increased profits due to business expansion or share repurchases.
If a business with a $10 stock price grew 20% for 10 years through a combination of expansion and share repurchases, it should be nearly $620 per share within a decade, assuming Wall Street maintains the same price-to-earnings ratio.
- Dividends: When earnings are paid out to you in the form of dividends, you receive cash via a check, direct deposit into your brokerage account, checking account, or savings account, or in the form of additional shares reinvested on your behalf.
Using a DRIP (dividend reinvestment plan) allows you to reinvest your dividends to purchase more stock in the company. This allows you to purchase fractional shares and steadily increase your stock holdings.
Occasionally, during market bubbles, you may have the opportunity to make a profit by selling your shares for more than the company is worth. And if you need cash for an unexpected emergency, having stock available to sell can provide a valuable financial cushion.
In the long run, however, your returns depend on the underlying profits generated by the operations of the businesses in which you invest. Choosing your stock wisely and holding onto it for the long-term is the most reliable way to generate wealth.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.