Stocks are shares of publicly-traded companies which are traded on an exchange. The percentage of stocks you hold, the industries in which you invest, and how long you hold them depend on your age, risk tolerance, and your overall investment goals. Discount brokers, advisors, and other financial professionals provide statistics showing the stocks that have generated outstanding returns for decades. Choosing the right stocks can mean big earnings.
However, holding the wrong stocks can just as easily destroy fortunes and deny shareholders lucrative profit-making opportunities. No amount of prior earnings will stop the pain in your gut during the next bear market, when the Dow Jones Industrial Average (DJIA) could potentially drop more than 50%, as it did between October 2007 and March 2009. Retirement accounts like 401(k)s and others suffered massive losses during that recession, with account holders ages 56 to 65 taking the greatest hit because those approaching retirement typically maintain the highest equity exposure and have the least amount of time left to regain earnings before they retire.
Making Money in Stocks: The Buy-and-Hold Strategy
The buy-and-hold investment strategy became popular in the 1990s, underpinned by the Nasdaq’s four tech horsemen — big tech stocks that financial advisors recommended to clients as candidates to buy and hold for life. Unfortunately, many people followed their advice late in the bull market cycle, buying Cisco, Intel, and other inflated assets that still haven’t returned to their lofty price highs during the dotcom bubble era. Despite those setbacks, the strategy prospered with less volatile blue chips, rewarding some investors with impressive annual returns.
The Importance of Risk and Returns
Making money in the stock market is easier than keeping it, as destructive algorithms and other inside forces are constantly generating volatility and reversals capitalize on the crowd’s herd-like behavior. This polarity highlights the critical issue of annual returns because it makes no sense to buy stocks if they generate smaller profits than real estate or a money market account. While history tells us that equities can post stronger returns than other securities, long-term profitability requires risk management and rigid discipline to avoid pitfalls and periodic outliers.
Modern Portfolio Theory
Modern portfolio theory provides a critical template for risk perception and wealth management. Whether you’re just starting out as an investor or have accumulated substantial capital, diversification provides the foundation for this classic market approach. It’s important that long-term players heed the warning that owning and relying on a single asset class carries a much higher risk than investing in a well-rounded basket stuffed with stocks, bonds, commodities, real estate, and other security types.
We must also recognize that risk comes in two distinct flavors: systematic and unsystematic. The systematic risk from wars, recessions, and black swan events—events that are unpredictable with potentially severe outcomes—generate a high correlation between diverse asset types, which can undermine diversification’s positive impact.
Unsystematic Risk
Unsystematic risk addresses the inherent danger when individual companies fail to meet Wall Street expectations or get caught up in a paradigm-shifting event. A good example of this is the catastrophic food poisoning outbreak that dropped Chipotle Mexican Grill’s stock value more than 500 points between 2015 and 2017.
Many individuals and advisors address unsystematic risk by owning exchange-traded funds (ETFs) or mutual funds instead of individual stocks. Index investing offers a popular variation on this theme, limiting exposure to S&P 500, Russell 2000, Nasdaq 100 and other major benchmarks. Both approaches lower, but never eliminate, unsystematic risk because seemingly unrelated catalysts can demonstrate a high correlation to market capitalization or sector, triggering shock waves that impact thousands of equities simultaneously. Cross-market and asset class arbitrage can amplify and distort this correlation through lightning-fast algorithms, generating all sorts of illogical price behavior. You can have gradual increases on ETFs with fewer risks, but you won’t get rich.
If you want to get rich on stocks then you need to accept that you could lose everything. This is to be expected; building immense wealth means more sacrifice, more time, more risk, and more potential pain will be part of your strategy.
What Strategy Is Best for You?
Determining the strategy best for you depends on the rate of return management you can earn by reinvesting your money. Sometimes companies paying out cash dividends is a mistake because their 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.
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. Buying a stock is buying a part of that company; you aren’t buying the stock because it’s going up or going down. You’re buying it because you want to own that company, either for short term or the long term. You are buying into that company and its risks and rewards.
Knowing the Risks
Knowing which stock to invest in and when to invest is all about risk management. The general rule is the more you risk, the more you stand to earn as well as lose. To be a savvy investor, you’ll need to tread the fine line between calculated and reckless risk, and as a result, make informed decisions to stay on that line. At the end of the day, investing in stocks is all about information. Information will let you know which stock to invest in, when and when not to invest, and how much you should risk. Yes, initially the stock market can be daunting, complicated, and downright unforgiving. But with enough information, experience, and patience, you can be making money investing. Prepare yourself to lose at first; it’s ok to lose money, it doesn’t mean you’re wrong, or a failure. It’s part of the cost of learning a new skill.
If you don’t have the time and patience to invest in stocks, try investing in pooled funds like UITFs. Experts will manage these funds for you while having full transparency and automatically diversified investments. Check out Dave Ramsey – he’s a careful investor who makes money with funds and advocates for paying for management. Do a lot of research on the style of investing you feel comfortable with. Don’t be hard on yourself, and have fun!
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