Cruncher is the pseudonym of an actuary working in London with experience in insurance, pensions and investments.
Stock market investing can be confusing and frightening for the beginner. There are so many choices to make of what to invest in, as well as many shares and funds to choose from.
But the basics of how people can make money from stocks and shares is very simple.
I'm not going to lie to you: just because it's simple doesn't mean it's easy to master. Baseball is simple. Doesn't mean we can all play in the major leagues. Skill in applying these ideas is what separates Warren Buffet from you and I.
But you wouldn't go and play baseball without learning the basic rules of the game or the basic strategies for winning.
And stock market investing is no different.
At its most basic, there are only three ways to make money from investing in stocks. (In fact some people would say there are only two ways. And that the first two of these are two sides of the same coin). These are:
- Buy low, sell high.
- Betting on price movements.
- Shareholder payments by the company.
(It'll help if you already have some idea of the difference between investment income and capital gains—if not there's a hand explanation here.)
Buy Low, Sell High
One way to make money is to buy stocks and shares in the hope and expectation that they will go up in value. Then you can sell them and make a profit, aka a capital gain.
It's a simple idea—but difficult in practice. Because you have to work out when to get in—i.e., when prices are low and about to go up—and when to get out.
Reasons you might buy in include:
- You believe that they are currently underpriced—i.e., they are good value so will go up in the long run. This is known as fundamental analysis.
- You believe that other people are buying—so prices will increase due to supply and demand.
- You have looked at patterns in the market (known as technical indicators) and believe that it indicates prices will go up. This is known as technical analysis.
Once you have bought in, you'll need to decide when to sell out again. It's a good idea to have a plan in advance. Otherwise, it's easy to let the excitement of things going well lead you to keeping a good thing for just too long.
In this style of investing ("going long" as its known), you are at least only risking the money you used to buy the shares. Worst case scenario is that they end up worthless.
However, it does require more money up front for the same volume of trading as you have to buy the shares outright.
If you want to make more money more quickly, you'll have to take more risk—and that's where the next type of investing comes in.
Betting on Price Movements
Instead of buying a stock or share outright, you can just profit from correctly predicting movements in the price.
You do this by investing in "derivative" contracts—called that because they derive from an underlying investment like a share.
There are many forms of derivatives, like:
- Forward contracts: This will allow you lock in a price now. You'll profit if the price moves in your favour, but lose if it moves against you
- Options: This will give you the option to buy at a set price at a set time in the future. You can profit if the price moves in your favour. And you have only risked the price of the option.
- Contracts for Difference (CFDs): These will pay out based on the difference between the price and a reference price. They are very similar to spread betting on sports.
Trading in derivatives can make more money more quickly than just traditional "long" investing. However you can also lose more money more quickly.
Generally this is only recommended for experienced, sophisticated investors. Or something done with money you can afford to lose. It's not a good home for your life savings.
Shareholder Payments by the Company
Companies often return cash to their shareholders. This can be in the form of dividends, or as a share buyback—where the company buys back and cancels a number of shares causing the price of the rest to go up by roughly the same amount.
Share buybacks can be popular as they give investors a capital gain, rather than income. In some places capital gains are taxed more favourable than income.
The amount of money return to investors depends on company policy, what other uses they have for the money (such as investing in future growth) and how well the company is doing.
Investing for dividends or buybacks can be a relatively secure long term investment strategy. It won't make you a fortune from nothing. But if you diversify your investments across a number of companies it should grow steadily over the long term.
Especially if you pick good value stocks in the first place. In fact this is what legendary investor Warren Buffet does on a grander scale. He identifies a company he thinks will earn good money in the long term and buys it or a piece of it. And waits. And that ability to pick the right companies has made him one of the richest men in the world.
Which shows that it's not always the high adrenaline high speed traders that do best in the long run.
If you are able to afford to take some risk with your investments you will generally be better off in the long term investing in some riskier asses like stocks.
I trust this article has helped you think more clearly about our investments, worry less and earn more. Before you go, please remember that none of this is financial advice and is provided for information only. You might like to consult a financial advisor in your jurisdiction who can provide advice tailored to our circumstances and how much risk you are willing and able to take.
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.
Gay Proctor on December 26, 2019:
I don't know to put $$$ in the stack market, will get $$$ back right?