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. 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 compound interest. This means that investors earn interest on the interest they've received.

You'll see the benefits when you earn interest on your total profit from capital gains and dividends. Over time, your investment will compound. It will continue to grow. 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). 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 shares at $1,000 each, just one of which was Microsoft.

Now assume 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 after doubling or tripling their money. The 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 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 a 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, are household names, have been in business for decades, and the 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.

Total value would work out like this: 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 were an index fund. You did nothing for decades except let the time value of money work for you.

Best of all, this analysis assumes that you spent every penny of the cash dividends that were mailed to you along the way. Had you reinvested that money instead, you'd have ended up even richer.

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 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:

  • Stick to stocks you know.
  • Diversify.
  • Reinvest your dividends.
  • Know when to sell a stock.
  • Choose funds that promote passivity.

Key Takeaways

  • Investing is 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.

The Balance does not provide tax, investment, or financial services and advice. This information is presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor. It might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.