The Mathematics of Getting Rich by Investing in Stocks

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One of the interesting things about investing is that it only takes one great investment, held for a long time, to change your family's destiny forever. Great fortunes arise from decades of holding stocks in extremely profitable firms that generate ever-growing earnings. Some refer to this approach as business-like investing.

The basic strategy for getting rich off stocks is to choose a profitable company and hold your investments for the long term. Such passive investing has the potential to make you very rich.

A Simple Math Example

Imagine it is March 13, 1986, the date a new company called Microsoft had its initial public offering (IPO). Cars that year retailed for around $10,000. But what if, instead of buying a car, you decided to purchase a block of shares in Microsoft? By 2020, that investment would be worth $13.7 million.

The power of a single good investment is that it is able to overcome a lot of disasters. Go back to 1986, only this time, assume that you divided that $10,000 into 10 different investments of $1,000 each, just one of which was Microsoft.

Assume you somehow manage to construct the single worst, awful, statistically improbable portfolio imaginable, and nine of your 10 holdings immediately go bankrupt the day after you acquire them. (Such a catastrophic thing is hugely unlikely, but for our example, say it's taken place in this alternate universe.)

How would you have fared? You invested $10,000 and immediately lost $9,000—90% of your investment is gone. But overall, you still did fantastically, believe it or not. By 2020, you'd still be sitting on $1.37 million, thanks to those 34 shares of Microsoft you bought in 1986. And that doesn't even include your cash dividends.

Whether it's a beachfront property acquired in Malibu 50 years ago or shares of Coca-Cola bought in the 1960s, a well-constructed portfolio can tolerate incredible doses of failure while still generating satisfactory returns thanks to compound interest.

Avoiding wipeout risk is key. As long as you can hang on and survive recessions, depressions, and liquidity crunches, things have historically worked out nicely.

Long-Term Investing Is Key

Here's the basic problem: Many people wouldn't have held their Microsoft stock for those three decades. A doubling or tripling of their money and they would have bailed—missing out on the incredible gains they could have made if they had stuck it out. Behavioral finance, or the study of investor behavior, shows that investors tend to make very human, repeated mistakes, and they don't always act rationally.

Therefore it can be difficult for investors to hold on for the long-term and ignore short-term fluctuations in price. This explains why index funds are so useful. The precipitous fall or meteoric rise of individual companies isn't apparent when looking at the index as a whole, and that can help investors avoid acting on emotion or fear.

Over the years, Berkshire Hathaway has seen shares collapse a few times. However, during that same span, because underlying net income and book value were increasing, the shares climbed and are now over $260,000 each. It was a bumpy road, with a lot of pain. Many owners, who didn't understand generally accepted accounting principles (GAAP) or the nature of equity investing, sold after seeing their brokerage account decline. Not only did they sell low, but they missed out on the rise following the drop.

Scenario: A Large Loss, But Gains Nonetheless

What if someone wasn't lucky or skilled enough to spot a Microsoft? It's a fair point. But the good news is, great businesses, especially boring ones, can be great investments. They don't all have to be Microsoft to be worth your while.

There are three things you need to do:

Let's go back to that same day in 1986. Instead of buying Microsoft, you decided to divide your $10,000 portfolio into two piles. In one, worth $5,000, you pick up shares of five of the bluest blue chips in the United States; companies that everybody knew, that had strong balance sheets and income statements, that had long been part of the index, that were household names, that had been in business for generations, if not nearly a century, and that paid dividends. You select a random list based on the darlings of the day: McDonald's Corporation, Johnson & Johnson, Hershey, Coca-Cola, and Clorox.

You use the other half, also worth $5,000, to speculate on high-risk penny stocks you choose yourself that you think have huge payout potential. You promptly lose that $5,000, meaning from day one, you are sitting on a terrible 50% loss of principal. Now, you're left with the so-called "grandma stocks." How'd you fare? Did these boring, ordinary names that promise a complete lack of sex appeal, excitement, or nightly news stories let you down?

Hardly! The chart below shows your total return on investment from 1986 to 2014.

  • Hershey: Your $1,000 grew to $24,525.92, of which $20,427.75 was stock and $4,098.17 was cash dividends
  • Coca-Cola: Your $1,000 grew to $25,562.42, of which $19,574.04 was stock and $5,988.38 was cash dividends
  • Clorox: Your $1,000 grew to $20,668.60, of which $16,088.36 was stock and $4,580.24 was cash dividends
  • Johnson & Johnson: Your $1,000 grew to $40,088.31, of which $31,521.17 was stock and $8,567.14 was cash dividends
  • McDonald's: Your $1,000 grew to $16,092.36, of which $12,944.39 was stock and $3,147.97 was cash dividends
  • Total Value: Your $1,000 grew to $126,937.61, of which $100,555.71 was stock and $26,381.90 was cash dividends

The Time Value of Money

Despite losing half of your portfolio at the outset, you still watched your $10,000 blossom by 1,269%. Your overall portfolio enjoyed a compound annual growth rate of 9.16%—although, what really happened was half your portfolio compounded by 11.8%, and the other half went bust.

You multiplied your money by large proportions, and did it without lifting a finger or ever again glancing at your portfolio, just as if you were an index fund, doing nothing for 29 years except letting the time value of money work for you.

Even better, this assumes you spent the $26,381.90 in cash dividends that was mailed to you along the way. Had you reinvested the dividends, you'd have ended up even richer.

The McDonald's calculation assumes you did not take any Chipotle shares during the 2006 split-off. If you had, the returns would have been significantly higher and made it one of the best-performing stocks in the portfolio, returning many, many times the amount shown here as the burrito chain rapidly expanded across the United States.

The Takeaway

What is the takeaway of all of this? Investing is simple and takes very few good decisions, properly structured, to make up for bad decisions. The key is to allow time to heal the wounds, be selective about what you buy, rarely sell anything, and focus on real companies selling real products or services for real cash.

Historically, that recipe has been a reliable method for producing millionaires. Stock trading and market timing (attempting to predict whether stock prices will be higher or lower in the future) may make for some interesting diversions but they aren't where the real, sustainable money is made.