Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).
Three Factors: Capital Appreciation, Dividends, and Options Strategies
When looking out at the dazzling array of rapidly changing numbers that represent how a particular stock is doing, constantly updating in real-time, it can be a little daunting to try to understand how you can expect to make money. "Number up good, number down bad" isn't really helpful, although it does call attention to one of the ways you can make money with stocks.
However, as we'll see, there are three possible components to how much return you get from any stock investment, and understanding how they can fit together can help you determine what type of investor you are. You don't have to take advantage of all three all of the time (or ever, really), but knowing what's out there and how you can use it will help you make your own informed decision. We're going to take a look at capital appreciation (sometimes also called capital gains), dividends, and options strategies in an overview format.
1. Capital Appreciation
When most people think of stock trading or investing, they immediately imagine the delightful future, where the price of their stock has gone up a great deal, and now they're fabulously rich. In between rounds of swimming in their money bin like Scrooge McDuck, they find time to buy another stock, it goes up, they sell, and so on ad infinitum.
This phenomenon is called capital appreciation, and you may already know that value investing is all about identifying mispricings in the market—cases where Mr. Market has assigned a price today that is far lower than the intrinsic value suggests.
Value investors love to see this price rise from the doldrums up to a range they might consider fairly or "fully" valued and then harvest their gains, especially if the price gets a little expensive. Most types of investors using all sorts of different strategies will aim for capital appreciation as their predominant, overarching goal when buying any stocks.
Even within the limited realm of capital appreciation, there are a few different ways you can realize this:
- the company can grow its business by reinvesting, and the stock can go up to reflect this higher intrinsic value
- the company can stay the same size but can improve its profit margin or cash flows, and then the stock can rise to reflect this
- price multiple expansion can take place where an entire industry has traded below its historic P/E (or other price multiple) ratio for a few years but reverts to its old multiple, or a new, higher multiple since a trend is now hot (EG all healthcare stocks move from a P/E of 10 to a P/E of 15 over a few years)
- an opportunistic price spike can be a fantastic opportunity for capital appreciation, although you need to sell before the dust settles (like a short squeeze or other quick jump that isn't necessarily based on fundamentals)
One final thing to consider with regard to capital appreciation is that you can experience this phenomenon in two distinct ways in your portfolio: you can hold, or you can take profits. If you're doing the latter, you're likely to harvest gains when your stock has moved above its intrinsic value or when you've made a nice profit on a mispricing, and you're more uncertain about how much higher it's going to go.
On the other hand, many value investors prefer to hold and will seldom sell; they prefer to harvest their capital appreciation over a much longer time horizon, and that has its own benefits.
"Do you know the only thing that gives me pleasure? It's to see my dividends coming in."
— John D. Rockefeller
Not all companies pay dividends, but for those that do, a dividend is an expected payment a shareholder gets just for owning the stock. You get this money regardless of whether the stock price goes up or down, so dividend income is often prized by someone looking for steady, reliable income from their portfolio.
Naturally, if you're trying to live off of your stocks, dividends are going to be a huge consideration, and you might be really happy with a stock that goes sideways (stays flat in price for a long time) but pays a respectable dividend. Be careful, though: dividends aren't guaranteed by law, and a company can decide to cut its dividend entirely or reduce it if conditions aren't great for them.
If you only consider the capital appreciation factor, you can get a really screwed-up perspective on the performance of a stock. Dividends can make up a huge percentage of annualized gains, and if you're not living off of the income, you can consider reinvesting the dividend into the stock itself (using a DRIP: a Dividend ReInvestment Plan), or you could keep the cash and decide where to invest it.
Keep in mind that dividends typically have historically made up around 40% of the total return of a big market index like the S&P 500. For many investors, dividend income is a much higher portion of their total return. Reinvesting your dividends creates an amazing flywheel concept of compound growth, and it's a powerful factor to consider.
3. Options Strategies
If dividends and capital appreciation can make you feel like Scrooge McDuck taking that famous money swim, options can make you feel like Peter Griffin splattering onto a solid metal surface. In other words, it's a good idea to understand options and use kid gloves when you're first dealing with them, if you even end up using them at all.
Many newer investors have jumped straight in and have started trading options immediately since there can be ultra-fast gains due to leverage, but many more have lost a great deal of money with the lightning-fast potential for unlimited losses if your strategy isn't sound. The main message here is to take your time and understand options before even considering trading them since they can amplify losses rapidly.
With that caveat out of the way, a more conservative approach to options trading involving only selling covered calls or cash-secured puts can "juice" your return by several percentage points per year and can quickly become a source of new money if you happen to need to generate cash, but don't want to sell the underlying stock. Options trading is recommended only after actively trading without them for a while.
The Stock Market Is a Wild Ride
Demystifying the stock market is something I've come to enjoy over the years, especially since it was just as bewildering for me before I started my own educational journey. Fortunately, I was given some great guidance early on and sought out Warren Buffett's letters to shareholders.
I gradually discovered some amazing value investing resources on the web and dipped my toe in the water in early 2020 with individual stocks. My timing couldn't have been better since the covid crash was right around the corner, and something like 10 years of trading activity and lessons were haplessly flung directly into my lap. As a result, I've been able to evolve from a pure buy-and-hold investor to a catalyst-seeking opportunist who will trade more conservative options.
My evolving understanding and gradually increasing sophistication are a part of my leveling up process, as I strive to understand the macro picture, fundamental analysis, and even some technical analysis in order to see the bigger picture. Taking a closer look at how money is made, with capital appreciation, dividends, and potential options strategies can help you decide how you want to play the game.
Come with me on this journey to understand how the market works, an endlessly fascinating area of study that nobody can understand completely, but everyone can observe and learn from.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2021 Andrew Smith