Whenever you hear about the money that investors make from the stock market, you’ll usually hear one of two stories.
The first is of the millions or billions that investors have made from the market. The other is of investors that have failed miserably and lost it all.
These extreme stories are not the reality for most investors. Then again, media outlets know that publishing a story of how a retail investor made $500 in a year isn’t so clickable.
In future lessons we will discuss the strategies that investor implement and why they are successful (or not). Today, however, we will go through how investors actually make money from the stock market.
When you buy a stock, the hope is that the stock price will go up. Why? Because when the stock price goes up, your money grows.
This is known as capital gain.
The term “capital gain” literally means that your money has grown, which is done when the value of an asset increases. In the case of the stock market, the value of an asset goes up when the stock price goes up.
A real world example though would be with a house. If you buy an investment property for $120,000 in 2002 and sell it for $200,000 in 2020, your capital gain would obviously be $80,000.
It’s important to note though that capital gain can be applied to most investments. For instance, if you were to buy gold and sell it for a profit, this would be classed as a capital gain.
Another key way that investors make money from stocks is with a dividend. This is different to capital gain because a dividend is technically income.
A dividend is literally a share of the earnings that a company makes in a single year. These earnings are past on to the investors.
Not every company offers a dividend, which has increasingly been the case in the last decade. Companies like Amazon have famously offered no dividend to investors, in order to use all of their earnings to grow the size of the company.
For that reason, companies that pay dividends tend to return less on the stock market with capital gains.
Famous companies that do offer dividends include Coca-Cola and McDonalds. Usually those companies try to grow their dividend each year to increase income for investors.
A typical dividend is around 3% of the stock price, but the dividend can go up to as much as 10%. The stocks listed on the London Stock Exchange typically have sizeable dividends, usually in the range between 5% and 10% per year.
To be more specific as to how dividends work, if you bought a stock for $100 and the dividend was 3% of the stock price, you’d receive $3 per year.
Dividends are usually paid quarterly but can be paid semi-annually or annually. Occasionally companies offer a dividend randomly to reward investors, which is known as a ‘special’ dividend.
In order to turn small amounts of money into very large sums of money, experienced investors that the best way to do it is to benefit from the effects of compounding.
Compound interest is when you make interest on the interest that has already been paid to you. With compounding, the money available to the investors becomes larger and larger, while the returns get bigger and bigger too.
For example, if you invested $100 into a stock and made 10% after one year, you’d be left with $110. In the second year, you’d then have $110 to invest, which would make $11 profit if a 10% return was achieved. For the third year, you’d then end up with $121.
If this processed continued for 10 years, the original $100 would eventually become $259.37 – which is $59.37 more than what would have been achieved with a straight interest rate of 10% a year without reinvestment.
For that reason, for compound interest to work, investor must reinvest any earnings that they receive through dividends.
Clearly $100 is not a lot of money and the returns don’t sound as impressive as if we were talking about turning $10,000 into $25,937 or turning $1,000,000 into $2,593,700.
Over time, returns can become enormous with compounding.
When investing in stocks, returns can be enormous over time. If we say that a stock returns 10% a year on average, this amount could be a lot different for other investors.
Warren Buffett, for example, purchased a large amount of Coca-Cola stock back in 1980s for around $1 a share. Today Coca-Cola stock is worth around $50 and returns around 5% a year.
5% growth from $50 is obviously $2.50, but for Warren the return would actually be 250% because he bought the stock for $1.
You can see that if you hold a stock over time, the annual performance can be enormous.
Unfortunately, investing is not a free activity and there are associated costs that can have an impact upon returns.
The major costs for most investors are transaction fees that are charged by brokers. Every time you invest, transaction fees will be applied, regardless of whether you are buying or selling.
In the UK, transaction fees tend to be around $10 per trade but they vary from one provider to another.
Brokers may charge you more if you invest in a stock that is listed in another currency or if you invest in a stock that is listed on a niche stock exchange.
To minimise transaction fees, the best thing to do is to trade are infrequently as possible. Brokers often give a discount if you trade frequently, which is within their interests as that’s how they make money. For investors though, the more you trade, the more transaction fees add up and the more reduced your returns will be.
The second most significant costs for most investors are management fees. As a standard, brokers tend to charge their clients an annual, semi-annual or quarterly fee for management services, things like having custody over your account or completing paperwork on your behalf. Management fees from your broker are usually small and often depend on the amount of money that you have in your account.
Management fees can also be incurred when individuals invest into investment funds. The companies that manage those funds typically charge a small management fee.
Finally, tax is another cost that is associated with investing.
Small investors may not pay much tax at all but for some investors, capital gains tax and dividend tax can reduce returns.
For smaller investors, stamp duty is more likely to be encountered in the UK.