The stock market can be oftentimes viewed as an auction house, where investors constantly buy and sell shares of publicly traded companies.
There are many ways on how people make money from the stock market. Generally, when it comes to traditionally investing in stocks, you can either make money by buying stock for a low price and selling it when its price has risen over time, or by dividends which is a proportion of the company’s earnings that are being paid out to its shareholders.
The Difference Between Investing and Trading
First, we have to distinguish between investing and trading. Trading by definition is buying and selling financial securities to make money in the very short-term and based on technical indicators and predictions. The time period of trades may already range from a few minutes to a few hours.
You have probably heard of all the successful day traders that make quick and easy money by sitting in front of the computer and clicking a few buttons a day. However, trading is not only extremely risky, but it’s also incredibly hard to make a consistent and stable income just from trading, even if all those gurus tell you that it is. Markets are unpredictable and you shouldn’t try to forecast the future with any technical strategy just because you will most likely be disappointed in the long term
Conversely, investing is all about finding great financial assets that can be held for a longer time period. Traditional investors don’t focus on any technical indicators of a stock and rather base their investment decisions on the fundamental and financial numbers of a business and the potential of its future growth. The earnings of a company are one of the most important factors that control the investor’s view and therefore, stock prices.
Traders and investors make money on the stock market in different ways. Of course, both make their profit by positive (or negative) stock price movements. However, as traders only hold their investments within a very short time frame, their success is already heavily determined by minimal price changes. That could already be, for instance, a price change of a few dollars or even less. And because anything can happen in the stock market, it’s impossible to not lose any money from trades and to always come out positively. Therefore, in the trading game, it’s much more about how many wins you have compared to your losses.
While on the other side, investors make their money by capital gains of a stock that they then can sell for a higher price after it grows. Little price movements don’t actually do any harm to most investors, as they already are determined to hold their stocks for a longer time frame. Besides that, a big proportion of companies within the stock market also pay dividends to their owners.
Dividends serve as an attractive source of constant investment income. Companies that do pay out dividends, do so as a distribution of retained earnings to thank them their stockholders for their ownership. Naturally, dividends make a stock more attractive, as most investors generally welcome an additional source of cash.
Can Investing Make You Rich?
First, you need to define what being rich really means to you. Passively investing in the stock market most likely won’t make you a billionaire, but it can probably ensure you being wealthy as soon as you retire. Investing is all about the long term and the principle of exponential returns plays an essential role in building your wealth. The compounding effect is what short term traders can’t take full advantage of and what made investors like Warren Buffett become one of the richest persons on the planet.
The average annual return of stocks has been historically sitting at around 8%. If we assume that you start investing when you are young and you continuously invest a little proportion of your income in the stock market, odds are that you are going to be a millionaire at the time you retire. Needless to say. Inflation also has to be taken into account and the same millions won’t likely be worth as much as they are today. That being said, investing is considered as one of the few ways that can completely passively make you rich, but it does take its time.
You can either reduce the time you need to achieve your investment goals by increasing the annual rate of return, or the amount of money you decide to invest.
The matrix above created by Lyn Alden shows how much money you would need to save to reach a certain amount of wealth after 25 years. You can see that the amount of money steadily increases with each percentage point of your annual rate of return. Also, notice that both the monthly savings and the amount of wealth you would accumulate are already inflation-adjusted.
As an equity investor, you primary build your wealth by
- Selling your shares at a higher price than you initially bought them. This is arguably the most common way on how to make a profit in the stock market. Over time, you want your holdings to increase in share price, as the businesses you invest in also grow and become bigger.
- Receiving dividends from your stocks as being a shareholder of the company. As already mentioned, many businesses decide to pay out a part of their earnings as a dividend to their shareholders which you would most of the time directly receive as cash into your brokerage account. That being said, not all companies pay out dividends and rather reinvest all their earnings into the business to max out potential growth. Examples worth mentioning are Amazon (AMZN), or Facebook (FB).