When it comes to ways to make money, there are a lot of options that may come to mind. But one of the most famous is making money in the stock market. Some of the most famous wealthy people made their fortunes in the stock market: Warren Buffet, George Soros, and Benjamin Graham to name just a few. And of course, stories of making enormous fortunes in the stock market have been immortalized in Hollywood through movies like The Wolf of Wall Street and The Big Short.
While all this sounds great, many people are still wondering: how do you actually make money in the stock market? What strategies or knowledge do successful stock investors use?
Well, there are actually several ways to answer this question, because there are several ways to make money in the stock market. This article will give a general overview of how you can make money in the stock market.
What Are Stocks And What Is The Stock Market?
First, let’s give a very brief overview of stocks and the stock market. Stocks are shares of equity in publicly traded companies. They represent ownership in a company. So, if a company has 100 shares and you own 5 of them, then you own 5% of the company. Of course, most publicly traded companies have hundreds of thousands – and often millions – of shares outstanding, so most investors only own a very small portion of the company.
The stock market is simply a place where stocks are bought and sold. In fact, the only reason that we know the financial markets as ‘Wall Street’ is that the New York Stock Exchange happened to be located there over two hundred years ago. Wall Street wasn’t a financial hub at that time – it just happened to be where the physical market for buying and selling stocks was located, and it hasn’t moved since then. These days, of course, there are many more stock markets that trade stocks of companies all around the world, but the New York Stock Exchange is arguably still the most famous.
Capital Gains To Make Money In Stocks
The first, and perhaps easiest to understand, way to make money in stocks is through capital gains. This is just an academic way of saying the price of your stock goes up, so you can sell it for a higher price than you bought it.
Capital gains are where most stock returns (or losses) come from, so the price of a stock when you buy it is an extremely important factor in determining how much money you make in stocks. It is so important that many stock investing strategies are based around capital gains. For example, Value Investing (a very popular investing strategy for the past several years) focuses on finding stocks that are undervalued in the market, so will increase in value in the future. Growth Investing focuses on finding companies that are positioned for high growth and so whose stock will likewise increase in value. In both strategies, investors focus on the future price of their stocks being significantly higher than what they paid, allowing them to make a good deal of profit when selling.
Make Money In Stocks With Dividends
Another, somewhat less interesting, method of making money in the stocks is through dividends. Dividends are cash that is given directly to shareholders by the company. Usually, dividends are a way for companies to distribute their profits to their owners (the shareholders) and are also seen as a way to make the stock more valuable to investors.
Dividends are not required to be paid, and many companies don’t pay them at all. For example, Alphabet – the parent company of Google, has tens of billions of dollars in cash but has never paid a dividend. Most companies try to have a consistent dividend policy from year to year, so usually buying a dividend-paying stock means you will continue to receive a dividend from that stock for the foreseeable future. However, it is important to remember that a company can stop paying a dividend at any time, so your future dividends are not guaranteed.
Although dividends are not as well-known, and for most people not as exciting, as making money through capital gains, they are still very important. Some studies have indicated that up to 50% of total stock market returns since 1940 are due to dividends.
A third option for making money in stocks is the exact opposite of capital gains: shorting stocks. Shorting stocks means that you bet against the stock, so that if the stock goes down you make money. But it is important to note that shorting stocks can be very risky, since you will lose money if the stock increases in price.
Let’s see an example: if you short Stock A when it is priced at $100, you are betting it goes down. If the stock then falls to $60, you make $40 (the amount by which the stock fell). However, if the stock goes up to $125 then you will lose $25. Since there is no limit to how high a stock can rise, in theory there is no limit to how much money you can lose when shorting stocks. On the other hand, stocks can only fall to zero, so there is a limit on how much money you can make shorting stocks.
You may be thinking: if shorting stocks is so risky why would anyone do it? Well, some people have made their fortunes shorting stocks. Short seller Jim Chanos famously shorted Enron stock and made an estimated $500 million in profit. Short selling is very risky but can turn into major profit for those who truly know what they are doing. But it is important to remember than even many professional investors openly acknowledge they wouldn’t be successful in short selling.
Active vs Passive Stock Investing
When investing in stock, any of the methods described above can work to make you money in the stock market. However, most people don’t use (or may not have easy access to) more complex stock strategies like shorting. So, if you are an average investor there are a few key strategies you should know about.
Active Investing just means that you have an active role in choosing the stocks in which you invest. In other words, you (or a manager you hire) actively research, evaluate, and buy stocks based on how you think they will do in the future. Active investing is the investing you usually see in movie and what you usually think about when imaging stock investing. And indeed, most famous investors in history were active investors.
The idea behind active investing is that you can evaluate the proper value of a stock, buy it if it is priced lower than its intrinsic value and sell it if it is priced above its intrinsic value. So, basically you can ‘buy low sell high’.
However, active investing in notoriously difficult over the long term. In fact, there is a good amount of data that shows active investors typically do worse than the market. So, you should be careful before starting to invest using an active strategy. Very, very few people can hope to match the runaway success of investors like Warren Buffet.
A second investing strategy is called ‘Index Investing’. Index Investing is a form of ‘passive investing’, which means that you don’t actively choose the stocks in which you invest. Instead, you buy a basket of stocks that are meant to represent a broad section of the economy. There are many different indices in which you can invest. For example, there are indices for the US market, the Asian market, technology companies, and more.
Passive investing is attractive to many people because it doesn’t require specific financial knowledge. So, it’s ideal for people who want to invest for their future but are not looking to make active decisions about their investments beyond broad industry choices. Investing in an index means that you don’t try to beat the market, you just try and match the general market performance by buying a wide range of stocks. Index investing is also less risky than stock picking because the price drop of any one stock doesn’t materially affect your investment. Index investing is so popular in the United States that Americans have invested trillions of dollars into index investing.
Despite being so simple, index investing is also very profitable. In fact, from the start of 2000 to the start of 2020, the S&P 500 index (one of the most popular indices in the US market) rose by over 130%, including the impact of the Great Recession and not including returns from dividends.
So, index investing is not sexy or quick, but it is one of the most reliable ways to make money in the stocks over the long run.
How Much Money Can You Really Make In Stocks?
So, after providing all this information on how to make money in the stocks, the question remains: will you actually make money in stocks? Well, the general answer is yes. Stock market investing is one of the most reliable ways to make money over a long period of time. What is less likely is the fast fortunes that usually come to mind when thinking about making money in stocks. But, if you are willing to be more realistic and patient, you can absolutely make money in stocks.