Getting Rich From Stocks: The Mathematics of Long-Term Investing

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One of the great things about investing is that it takes only one great purchase, held for a long time, to change your family's future. Great fortunes arise from decades of holding stocks in firms that generate earnings that are always growing. Some refer to this approach as "business-like investing."

The basic strategy for getting rich from stocks is to choose a profitable company and then hold your investments for the long term. This type of passive investing has the potential to make you very rich indeed.

Getting Rich Means Long-Term Investing

Buy-and-hold investing is an easy way for most people to gather wealth from stocks. The secret is the power of compounding.

You'll see the benefits when you receive returns on your total profit from capital gains and dividends. Over time, your investment will compound, but the real perk of a buy-and-hold plan is that it can withstand some missteps. A well-constructed portfolio can stand up to large doses of failure while still bringing in nice returns.

The Power of a Good Investment

Imagine that it's March 13, 1986, the date that a company known as Microsoft had its initial public offering (IPO). Many cars retailed for about $10,000 in that year. But what if you had purchased shares in Microsoft instead of buying a car? That investment would be worth over $25.8 million by 2021.

The power of a single good investment is that it's able to survive a lot of disasters and mistakes. Let's go back to 1986 again. Assume that you had put that $10,000 into 10 different stocks at $1,000 each, just one of which was Microsoft.

Now suppose that you somehow managed to construct the worst portfolio ever. Nine of your 10 holdings go bankrupt the day after you acquire them. How would you have fared?

You invested $10,000 and lost $9,000 right away—90% of your investment is gone. But you still did great overall. You'd still be sitting on $2.58 million in 2021, thanks to those shares of Microsoft that you bought in 1986. And that doesn't even include your cash dividends.

Avoiding wipeout risk is key. Things historically work out nicely when you can hang on and survive recessions, depressions, and liquidity crunches.

Holding Is Key

Many people wouldn't have held their Microsoft stock for those three decades. They would have bailed out after doubling or tripling their money. They would have missed out on the great gains they could have made if they had stuck it out.

Behavioral finance is the study of investor behavior. It shows that people tend to make very human mistakes, and they repeat them. They don't always act rationally. It can be hard to ignore short-term fluctuations in price. This is why index funds are so useful. The fall or rise of a company isn't apparent when you're looking at the index as a whole, and that can help you avoid acting on emotion or fear.

Berkshire Hathaway has seen its shares collapse a few times over the years, but its shares have climbed over that span because underlying net income and book value were going up. Shares are over $425,000 each in 2021.

Long-term investing is a bumpy road, and it can bring a lot of pain. Many owners sell after seeing their brokerage accounts decline. They don't understand generally accepted accounting principles (GAAP) or the nature of equity investing. Not only do they sell low, but they miss out on the rise after the drop.

An Example: Investing $10,000 in 1986

What if someone wasn't lucky or skilled enough to spot Microsoft? The good news is that great businesses, especially boring ones, can be great investments. They don't all have to be Microsoft to be worth your while.

Let's go back to that same day in 1986. Let's say that instead of buying Microsoft, you decided to divide your $10,000 portfolio into two piles.

From one pile, worth $5,000, you pick up shares of five of the bluest blue chips in the United States. They're companies that everybody knows. They have strong balance sheets and income statements. They've long been part of the index, they're household names, they've been in business for decades, and they pay 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 pile, also worth $5,000, to speculate on high-risk penny stocks. You choose these yourself. You think they have huge payout potential. You promptly lose that $5,000.

You're sitting on an awful 50% loss of principal from day one. You're left with the so-called "grandma stocks." How did you fare? Did these boring names that promise a complete lack of sex appeal or nightly news stories let you down? Hardly! The chart below shows your total return on investment from 1986 to 2014.

Your $1,000 in Hershey grew to $24,525.92, of which $20,427.75 was stock, and $4,098.17 was cash dividends.

Your $1,000 in Coca Cola grew to $25,562.42, of which $19,574.04 was stock, and $5,988.38 was cash dividends.

Your $1,000 in Clorox grew to $20,668.60, of which $16,088.36 was stock, and $4,580.24 was cash dividends.

Your $1,000 in Johnson & Johnson grew to $40,088.31, of which $31,521.17 was stock, and $8,567.14 was cash dividends.

Your $1,000 in McDonald's grew to $16,092.36, of which $12,944.39 was stock, and $3,147.97 was cash dividends.

Overall, 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

You multiplied your money by large proportions in this scenario. You did it without lifting a finger or ever glancing at your portfolio again, just as if you had owned an index fund. You did nothing for decades except let the time value of money work for you.

The McDonald's part of the calculation assumes that you didn't take any Chipotle shares during the 2006 split-off. The returns would have been much higher if you had.

How To Choose for Buy-and-Hold Investing

"Boring" stocks—the kind you might never give a second glance—are often the best.

Best Buys Hidden in Plain Sight

You still watched your $10,000 blossom despite losing half your portfolio at the outset, even though half your portfolio compounded, and the other half went bust.

3 Characteristics of a Great Long-Term Holding

Good investments tend to combine three characteristics: strength, valuation, and stewardship. These stable, well-managed companies will help you get rich slowly, which is the most reliable method of building wealth.

Look for companies with leadership that seems to be invested in their shareholders' best interests. You want to invest only in those that will respect your money.

The Tricks of the Trade

All investments come with a certain amount of risk, but a few tricks of the trade can help you reduce exposure and maximize profit. Keys to building a portfolio of good stocks include:

  • Sticking to stocks you know
  • Diversifying
  • Reinvesting your dividends
  • Knowing when to sell a stock
  • Choosing funds that promote passivity

Key Takeaways

  • Investing can be simple. It takes very few good decisions, properly structured, to make up for bad decisions.
  • Allow time to heal the wounds. Be selective about what you buy, rarely sell, and focus on real companies that are selling real products or services for real cash.
  • Stock trading and market timing aren't where the real, sustainable money is made.

Frequently Asked Questions (FAQs)

When you sell a stock, who buys it?

Traders rarely know who exactly is buying a stock when they sell it. Someone is buying the stock, but it could be a hedge fund, a retirement fund, or another individual like you placing a buy order on their phone app.

What does it mean when a company buys back stock?

A company buys back stock to increase the share price and consolidate ownership. By buying back stock shares and destroying them, the company's existing market cap is suddenly spread across fewer shares and fewer owners, so the remaining owners own a larger piece of the company.

When a company buys another company, what happens to your stock?

When a company buys another company, the effect on existing shareholders depends on the deal that was struck between the two companies. If it's an all-cash buyout, then shareholders of the company being bought will receive cash. In other situations, shareholders may receive stock from the purchasing company to replace the stock being bought.