Dear daughter,
This was one of my first questions when I started reading about investing in the stock market: how do you make money in the stock market?
It was challenging at the beginning, but once you read for a while, the answer just comes to you without any effort from your side.
But I want to give you a head start so you don’t have to wait until you read a few books.
I believe it is important to know the benefits of doing something from the beginning. That can give you the right motivation.
What is the next step after getting motivated? Take action!
Here is something that I hear every single day when I listen to my favorite podcast.
Inspiration is good, but inspiration with action is so much better”
Chris Guillebeau
You make money in two ways in the stock market:
- Buying at a lower price and selling at a higher price
- Getting paid dividends on the stock you own
1- Making money buying at a price and selling at a higher price
This one is the favorite way of making money for value investors.
If you buy when the stock is underpriced and sell it when it is fairly priced or overpriced, then you make a good profit.
This sounds simple but there is more to it.
For instance, you have to consider the transaction costs. Every time you make a transaction in the stock market, there is a cost involved. That is how the companies (yes, more than one) that make possible the transactions earn money.
Another consideration is the tax implications. I’m not a tax expert but, when you earn money, that money is taxable. However, under certain conditions, you can deduct a portion and in a certain types of investments, like real estate, you can even deduct everything and not pay tax at all.
So, the main point here is, that when you make a transaction, you need to think about the cost and tax implications of the transaction.
Some investors say that the difference between positive and negative cash flow (if you earn or if you lose money) sometimes is in the costs of the transactions and the tax implications.
Also, value investors said that you don’t make money when you sell, you make money when you buy.
How so?
If you buy a stock for 20% less than its intrinsic value, when the stock reflects its intrinsic value in the stock market, you just make a 20% return on your investment. That is the meaning of “making money when you buy”.
2- Making money with dividends from the stock you own
I have to tell you this, this is my favorite way of making money in the stock market.
I’m not a professional investor, I know. Also, I’m not giving you advice on what you should do. I’m just telling you this one is my favorite. You should analyze the pros and cons of each one, consider your current situation, and then take action.
As I mentioned to you here, each shareholder (owner) is entitled to a portion of the company’s profit.
A company can distribute dividends once or more times a year. The one I bought pays dividends twice a year.
Why do I prefer this type of income?
Because I don’t have to sell anything to get some profit.
Tax on dividends can qualify for a discount under certain conditions.
When you receive a certain amount of money, twice a year, just to allocate your money to the right stock/company, you can get a lot of motivation to keep doing the same.
The price of the stocks that pay dividends can also grow.
So, in this case, you can earn from the dividends. Also, if you decide to sell and the price is higher than what you paid for it, you get “another” profit. In other words, the return on your investment will increase.
Of course, you can make money in both ways. You can have a portfolio with two types of stocks, some that don’t pay dividends and some that pay dividends.
Professionals’ financial advisors and some professional investors will tell you this: you have to diversify.
Diversification means not putting all your money in one stock. It is better to have several stocks or several baskets. In case one investment goes wrong (which is a possibility), then you don’t lose everything.
However, Warren Buffet says that diversification is something for people who don’t know what they are doing.
He said, when you compare two investments, you will see that one is better than the other one, in terms of how much money you can earn from the investment. So why will you put money in the second-best? It might be because you really don’t know what you are doing.
Dear daughter, in my case I diversify by buying a mutual fund and an Exchange Traded Fund (ETF). I’m still learning and there is much to learn, so I must cover myself in case of a bad decision. I will qualify as the person that does not know what I’m doing.
Remember that when you buy an ETF, you buy a basket with several stocks on it. ETF follows indexes on the stock market. The indexes usually have stocks that meet certain requirements and if one of them does not meet the requirement anymore, is removed from the index and a different one is added.
However, I also picked one stock myself and invested some money in it. So far, this one is going great. Actually, is doing better than the mutual fund. And it passed the test of the COVID pandemic. This one is definitely a great business.
I choose to have the three investments (1 stock, 1 mutual fund, and 1 ETF) so I can really understand the differences between them. One thing is what you read and learn, but only the experience will make you grow.
Remember, “Inspiration is good, but inspiration with action is so much better”.
Love you, Dad.