Most of the time, just spending less than what we earn will not be enough to meet your financial goals. This is why it’s important to invest our money over time and put it to work, and as such, why not choose stocks, the best possible way to reap the highest returns over time?
Even though stocks may seem alluring, this investment type is one of the most volatile and risky. In the short-term, the value of stocks can drop significantly, and with just a little bit of bad luck or bad timing, you can easily lose all of your returns. This is why it’s important to take a long-term investing approach. More on the concept of long-term investing later!
There’s never a guarantee that you will reap profits; you just have to educate yourself and assess your risk relative to the expected reward. Still, without a doubt, your money works hardest lying in stocks than in any other investment, or asset class, hands-down.\
Have you ever heard of Warren Buffett? He is an icon in the investing world and one of the largest proponents of a concept called value investing. In short, this is the strategy:
“Long ago, Ben Graham taught me that price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” - Warren Buffett
Value investing is focusing on buying shares of companies that are undervalued. This means that investors should only buy the stock if the price is below its intrinsic value. Essentially, the stock should be a bargain for your buck. Your decision on whether or not a stock is undervalued is based on your own fundamental analysis. As a beginner, this is objectively the best strategy to start out with.
Before you put your money into any stock, be sure to thoroughly analyze and understand the company you are investing in. What’s the company’s long-term plans, its business principles, past earnings, financial structure? Because there is a profound focus on value investing on steady returns, companies with consistent dividends are ideal because it is a sign that these companies typically are mature and profitable. Value investors do not look at short-term price trends as a gauge for companies, nor do they look at its popularity. More on looking at financial statements and assessing industry trends in later units.
When building your portfolio of stocks, don’t put all your eggs into one basket. Diversification reduces risk by investing in stocks of different classes, thereby protecting them from serious losses in one particular stock. You win some, you lose some. This approach typically guarantees steady annual returns.
Everyone on the stock market wants to make money fast, especially new investors. What is hardest to grasp though is that few of us want to put in the effort to get safe, steady returns that last over time in lieu of stocks that offer extraordinary returns in a short period of time. At one point, however, the latter strategy will fail. Value investors want to see consistency. After all, if you’re trying to beat the market and reap high and immediate returns, there’s no way you can out-smart the professionals who do this as a job.
In the most simplest breakdown, this is how being a shareholder can reap profits over time:
Price Appreciation
When a company grows, your piece of the pie increases too. When buying stocks on an exchange, you can wait for your stock price to appreciate (increase) and sell the stock for a profit!
Some companies pay dividends. These are typically quarterly payments to shareholders that come out of the company’s pocket in retained earnings -- the remaining net profit of the company after taxes, depreciation, etc. They are usually a relatively small fraction of the share price.
Individual stocks typically fluctuate wildly in prices, on a daily, weekly, monthly, and yearly basis. They are typically hard-to-predict and could vary for a wide range of reasons, such as company specific news, earnings announcements, and industry news. In fact, on the New York Stock Exchange, a typical stock could have a 40% price difference between its yearly high and low.
But still, there’s a bright side; investing towards the long-term. In spite of all the volatility and risks associated with the short-term, stocks have consistently shown the highest return of any investment type. Even through the huge market dips and crashes, the market always comes back. Generally, we will see most long-term investors generally will hold onto their stocks for an extended period of time and see the value of their stock increase. In the long-term, stocks generally outperform.
In addition to this, the power of compound interest coupled with time will be clear: the longer you invest in your stocks, the better off you will be. Time also helps to reduce the variation associated with expectations in return and will increase your likelihood of positive returns.