Can We Really Make Money in Stock Market

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Can we really make money in stock market - MakeLivingGoodThere’s lot of talk about making money in stock market. Internet is full of wall street analysts advising people on which stock could be next big multi-bagger. There are TV news channels which run entire day talking about stock market. How can it be possible for them to suggest a new stock almost every single day? I was thinking about it for some time now. As mr. Buffet rightly said, stocks have real companies behind them. And from my experience working with corporate world; I know that dynamics of companies do not change daily, weekly, quarterly or even yearly in most cases. Then how come there’s always a new idea to invest in stock market? In fact these ideas are so confusing that while one wall street advisor is recommending to buy a stock, at same time another is saying we should sell it.

I really wanted to understand if a common man like us,  can make money by investing in stock market or not. Specially in this chaos and constant noise at wall street, can we really make any money in stock market?

What follows in this post are some of the questions that I asked myself with answers. So, lets dig into it and start with some basics for those who are new to stock market and equity investments.

disclaimer: I am not a stock advisor or financial consultant. I may have biased views towards some investment ideas due to my personal understanding and research.

What is a Stock

A stock which is also known as a ‘share’, is a piece of a company or a business. For instance Apple is a company with over 5 Billion shares as of today. Say you bought 1 share of Apple today. Congratulations you just owned 0.00000002% of Apple’s business. Owning shares is the easiest way of owning a company. But how do you buy a share at first place? The answer is coming in next section.

There’s an awesome book that every investor must read and I strongly recommend you to check it out before making any investments in stock market.

Let’s see how a stock market works.

How Stock Market Works

In order to find how to make money in something, we must understand how it works first.

A stock market is a place where people buy and sell stocks of companies. The two best known exchanges in the U.S. are the New York Stock Exchange (NYSE) and the NASDAQ, but there are also fourteen others that facilitate trading in stocks.

Imagine there is a super store such as Walmart or Target. At any time these stores have thousands of products on the shelf for us to buy. We can pick whatever we like, pay for it and that’s how we own it.

In a nutshell, stock markets have same process. We can go to any of these stock exchanges; pick shares of the companies that we like, pay for those shares and we own those shares until we decide to sell them. The core difference from pick items from our favorite super store is that; we don’t need to physically own the shares anymore in this digital world. Our shares are digitally stored at a central depository and we can access them through a demat account.

In past, there used to be physical stock markets where investors had to physically go to buy the stocks and they get a paper certificate indicating number of shares bought, price and company. But today, every step of purchasing or selling a stock in available online through demat accounts.

A demat account is just like a bank account which allows us to buy and hold shares of companies in it. We can buy or sell share of any listed companies during working hours of stock market. If you are interested in opening a demat account then there are many companies offering low trading fee demat accounts today in US. Here are few:

Best Online Brokers for 2018 - MakeLivingGood

source: nerd wallet

I personally like and use Robinhood which charges no commissions ($0) on stock trading and is also free to join. It has very cool app that simplifies the stock market investing and I highly recommend you to check this out. If you sign up with my link, you will also get one free share of any US company with maximum value up to $200, just for registering with them which takes less than a minute. In fact, they also offer a free service to buy crypto currencies (like bitcoin, ripple, etc) nowadays for $0 transaction fee. I had an account with another stock brokerage firm earlier. Robinhood also offers free transfer of our existing shares to their platform which means that when I will sell my shares on Robinhood, there will be no trading fee charged for the transaction which is great. So far I am loving their app.

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Once you have a demat account setup, transfer money into it from your bank and then you can buy stocks of any company traded on stock market. It’s that simple.

Passive Income through Stocks

Stock market can provide a good source of passive income. One of the common ways investors generate regular passive income in stocks is through dividends. As of today, there are many stocks offering favorable dividend returns in US.

S&P500 Dividend Yields-MakeLivingGood

Source: finviz

Here are few great books (& book) that read to learn about stock market investment and generating regular income through dividends.

Here are few other ways to build wealth:

Stock Market Crash

Anyone who follows local news, might have heard about great stock market crashes in our history. Specially one in 1929 (Great Recession) in USA, another in 2000-01 (Dot com bubble) and most recent one in 2008-09 (Housing market crash). The stock market crashes are inevitable. They have occurred in past and will keep happening in future. No one can do anything about them. This is the bitter truth.

Stock market Movement - MakeLivingGoodWe should think about stock market crash as follows. Anything that goes UP will also come DOWN some day. It is in nature of markets. I believe crashes make markets more efficient by bringing them closer to their real intrinsic value. Ofcourse, on some occasions, the stock market will be below its intrinsic value and that offers great investment opportunities for anyone seeking bargains.

So, stock market crashes aren’t enemies of a value investor. They are in fact friend of ours if we are ready for them. I will briefly talk about how to be ready for a stock market crash later in this post. For now, let us do some analytical research on how often stock markets had crashed and by how much.

On a quick side note, I think you will be interested in knowing how a sequence of yearly returns can make or destroy someone’s portfolio. It’s plain math but still missed by many investors. Read more about it here – Why is Order of Rate of Return so Important 

Stock Market History

Let’s take a look at how often stock markets have crashed in last century or two. For this research, we will look at 189 years of stock market history. Although this doesn’t guarantee for future market returns or crashes, but it’s a good perspective to look at how markets behave in short and long terms.

Please click the chart below to zoom and look at it for a while.

Stock Market Historical Returns - MakeLivingGood

source: Robert Shiller

Above chart is based on data put together by Robert Shiller, and he used a price weighted index approach to derive this which has many flaws, but still this is the way in which most of the indices are measured today. So, we can still use it for our analysis.

Read More: Ever wondered why Warren Buffett trust index funds? Because Knowledge is the Power in Investing World and he has plenty.

The horizontal axis shows the ranges of stock market returns and vertical bars are financial years (from 1825 – 2013) in which the market returns were in those ranges. For instance, in year 2013 (third bar from right), the stock market return was in range of 30-40%. In 1933 (extreme right bar) the market return was in range of 50-60%. As you will notice there are very few years on the extreme sides of above chart. In other words, rarely stock market returns are astonishingly on high side of 50-60% in a year or losing -50 to -40% on negative side. According to above chart, only 2.6% of times stock market returns were 50-60% (excellent) and just 0.5% when markets lost over 40-50% in a year in almost last two centuries.

In fact, in last 189 years only 29% of times market lost money while 71% of times it closed year with positive returns. But majority of us are still scared of market crashes.

Here’s summary of my key findings from above chart:

  • In 70.9% of cases stock market’s annual returns are between 0 – 60% while in 29.1% cases, stock market closed with negative returns.
  • In other words, market had 134 positive years and 55 negative years out of total 189.
  • 46% of times market returned 10+%.
  • 44% of the times, market closed with returns between 0-20%.
  • 25% of times, market lost under 20%.
  • Only 14% of times, market did worse than -10%.
  • Mere 4.8% of times (fewer than 1 in 20), market lost more than 20%.
  • The market was 5 times more likely to be up 20% or more in a year (50/189) than down 20% or more in a year (9/189).

To use a different time period and a different yardstick, Buffett once mentioned that the DOW went from 66 to 11,219 during the 100 years time period during the 20th century, which is a 5.3% CAGR. Add dividends to that figure, and shareholders might have realized 7-8% annually or so in last 100 years. In other words, investors who stayed invested in the stock market had made money.

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Is it good time to Invest today

Make no mistake, market will crash from time to time. It’s not possible for anyone to know when and how much.

Look at the above chart again and notice that market was down 30% or more only 3 times in last 189 years. Markets go down by 10% in every 3-4 years and by 20% once every 5 years on average according to pattern seen above.

Also notice that the returns in subsequent years after crash or negative yields, were generally above 30%. In other words, after negative years the stock rally continues for sometime before a stock market crash comes again.

Let me prove it to you with some recent data. Below is a chart from october 2017 to april 2018.

Stock Market Returns - MakeLivingGood

source: yahoo finance

In just 6 months, S&P 500 index went down by 10% twice. If we want to overlap this with our earlier study for 189 years, then this chart falls in 15% category where stock market returns were down by 10% in a year.

To reinstate what I mentioned earlier, it is in nature of stock markets to move up and down all the time.

So, again there is no good or bad time to start investing unless someone doesn’t know how and where to invest. Here are few books which helped me learn about stock market investment. I highly recommend you to check them out. book1, book2, book3 & book4

Should we wait for a Crash before Investing

Honestly, I was waiting for a stock market crash myself. Then I did this research which made me think it’s a waste of time to wait for a crash to happen. As we discovered, crashes do happen from time to time which could provide a favorable opportunity for an investor to buy some good companies at discount.

Considering that major market crashes (greater than 30% negative) had only occurred 3 times in last 189 years. On average 1 major crash every 65 years. If we think like this, then it may not sound reasonable to wait and sit on side lines.

As shown above, smaller downturns (under 10% negative) can happen multiple times in a year though which could provide a good entry point for someone waiting to get in.

If you are still scared of high markets today, I would share the approach that I use which is to set up an automatic systematic investment of up to 30% of an investment pool into equities and keep 70% in bonds and other secured investments. This approach is inspired by Ray Dalio’s – all season approach. When the market is in its downturns, then start raising that 30% to whatever point you are comfortable with. This approach will give anyone 2 things: first a peace of mind that you are not waiting on side lines and secondly it will satisfy your itchy fingers which are eager to press the investment button.

What should we do

As most successful investors do, we should not spend any time thinking about economic failures or market crashes. Rather, we should focus on individual companies which we can buy at reasonable prices today and hold them for a long time.

I know this is easier said than done. We all are scared of buying at peak and losing 10% of portfolio next week. That is why I think anyone who isn’t ready to see his/her portfolio down by over 50% at a time; shouldn’t even bother to enter the market. It is not good for peace of their mind. Most investors make this mistake. They aren’t ready to lose but only to gain. But that’s not how stock market works.

Here are few books( & book) that I highly recommend for anyone who wants to learn how to pick good companies at reasonable price.

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Below are things that anyone can do who is waiting with some cash and looking to deploy it into some  investments.

Dollar Cost Averaging

If you still want to invest and sleep peacefully in night, then dollar cost averaging is recommended way to go. As Tony Robbins says, asset allocation is the theory and dollar cost averaging is how to execute it.

asset allocation is the theory and dollar cost averaging is how to execute it.

In dollar cost averaging or systematic regular investment approach, you invest fixed dollar amount regularly in direct stocks or mutual funds. Over the time, your purchase price is spread over various peaks and fluctuations that occurred in the market during your investment period. The dollar cost averaging will protect you from buying at one single price point. Dollar cost averaging is a way to diversify your investment across time.

To illustrate my point with an example, here are two scenarios for you. In first scenario, the market is very volatile and moving from -35% to +35% in a year. On year 1, suppose the stock that you want to buy is available at $100 per share. You want to invest fixed dollar amount of $10,000 a month for next 10 years. So, $10,000 invested on first year’s January month will let you buy 100 shares of this company or mutual fund. In year 2, the price of share went down by 35% to $65. Now you can purchase little more shares for same $10,000 amount as the per share price went down. For simplicity sake, we are assuming that share price stays same on the day you purchase it every month.

In next 10 years, continuing with this investment plan; you would accumulate 12,783 shares at total investment of $1,200,000. Your net return after 10 years will be 6.52%. Notice that share price has come to same $100 price after 10 years. So, share didn’t grow as such in 10 years but you still managed to make money in it. This is the power of dollar cost averaging.

Dollar Cost Averaging in Volatile Market - MakeLivingGood

Now consider scenario 2. In this scenario, the market is booming and so is your stock. It’s price is going up consistently for next 10 years. On January of first year, share was available at $100 a piece. Next year it grown to $105 a share until year 10 when its price was $145. Since you were accumulating the shares consistently every month with fixed dollar amount your average price point was going up with the price of the share and you were getting fewer shares every year for the same invested amount. By the year 10, you would have accumulated 9,934 shares with same total investment of $1,200,000. But since the price of share has grown substantially in recent years, your net return is around 20%. Again, this is the power of dollar cost averaging.

Dollar Cost Averaging in Bull Market - MakeLivingGood

You would ask what about if market is doing down only like in a bear market. In that case you would accumulate more number of shares for same $10,000 invested. So, when market comes up, your returns will be substantially higher than above 2 scenarios. Dollar cost averaging works in all 3 scenarios in your favor including volatile market.

On other hand, I also believe that any investor should also be ready for crashes. What I mean is that, we should keep a portion of our portfolio in cash too. Ideal size would be at least 10-15% in my opinion. This will provide us extra cash to invest when market offers us favorable opportunities in future. But at any time majority of our portfolio should be in some kind of investments which is yielding returns.

As Charlie Munger said,

sometimes the tide will be with us and sometimes the tide will be against us, but the best thing to do is to just continue to swim as competently as we can. Although ocean tides are much easier to predict than the direction of the stock market, I still think it’s best to focus on swimming as opposed to anticipating the changes in the tides

Finally, I would love to know about your strategy to invest in stock market, counter crashes and build a great portfolio. Let us meet in the comments below.

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Can We Really Make Money in Stock Market

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