Investing in Stocks 101

I’ve covered in a previous article that most Singaporeans won’t ever have enough to retire despite working all their lives, and I’ve also dealt with certain money myths that keep most of us from acquiring enough money to meet our financial goals in another article. The first article covered the When (When will we have enough money?), while the second article covered the Why (Why do we never seem to have enough?).

We are now ready to tackle the last, and arguably most important question: How. How do we get enough money?

You may have probably guessed from the article title that the answer I am going to propose lies in stocks. To many, stocks are incredibly complicated investments, and risky to boot. There are countless tales of people getting badly burnt in the stock market, and as a result, many shy away from investing their money in stocks. Therefore, before I delve into how stocks can help you achieve financial freedom, we must first overturn some pervasive myths about them, or you will never find the self-confidence to actually put your cold hard-earned cash into such an investment.

Myth #1: Stocks are incredibly complicated investment products.

What comes to mind when one imagines stock trading? Probably an image of endless charts, esoteric indicators, loads of people shouting in a trading pit, and all sorts of numbers and percentages. If you’ve ever switched to a financial news TV channel like Bloomberg, it’s easy to see where such a perception arises. The financial information comes every minute of the day, making investing seem like an extremely intense activity that is not for the fainthearted or prudent.

Personally, if stock investing really was like the above, I wouldn’t do it either. However, I won’t say that the above is a gross misrepresentation of the stock market – there really are people who read such charts, study such indicators, and so on. The reason why I can say this is due to the difference between Trading and Investing. To most people, the two are the same, but in reality, they are very different. The difference lies primarily in the length of time the stock is held. For a trader, the length can range from mere minutes to a few days at most. To make money in such a short period of time requires extensive and detailed knowledge of the above-mentioned things. But for an investor, who holds the stock for months and years, such information is not necessary – in fact, to the stock investor, such short term fluctuations in the stock price is just noise – it doesn’t change the general trend of whether a stock will rise or fall over the long term.

Myth #2: Stocks are very risky investments.

What makes an activity risky? Is climbing a mountain risky? Driving a car? Traveling to Country X? It depends, right? Of course we have stories of people doing a certain activity and experiencing a negative outcome, but there are countless other people who have done the exact same activity and never experienced any negative outcome. What is the difference between these two groups of people? It’s simple. One group understands the risks involved and how to control these risks, and the other group doesn’t. Understand the risks of any activity and how to control them, and suddenly that activity will not seem so dangerous after all. This applies to anything from riding a bike to taking a cooking class, and investing in stocks is no different.

Myth #3: Only financially-trained experts can invest in stocks or manage such investments for others. I can’t do it because I don’t have the knowledge.

Don’t get me wrong – knowledge is an important part of investing. I will not sugar-coat the facts: A stock investor has to have a basic understanding of some financial concepts in order to be successful. The good news is that this basic understanding is something that anyone can obtain. Once you gain this understanding, you will have taken the first step towards financial independence. No longer will you have to listen to “experts” who charge you exorbitant fees to invest in something which gives you a low rate of return. You work hard for your money, don’t you? Now make your money work equally hard for you.

To know where to begin, start at the end.

Let’s return to the main question: How to get more money. And when I say money, I really do mean cold, hard cash you can feel in your hand. I have to define money very carefully here, because when you hear people talk about stocks, they often talk about stocks they bought at dirt-cheap prices, which later skyrocketed to insane amounts. Okay, that’s all well and good, but has it translated to an actual increase in wealth?

No. Here’s the first principle of making money in stocks: You haven’t made any money in the stock market unless you can see the balance in your bank account rise. What happens in the stock market – all your paper gains and losses – stay in the stock market, until you sell the stock. The main goal here isn’t a pretty portfolio of stocks that look great on paper but don’t add a cent to your bank account – you want actual money that you can actually spend.

Speaking of cashing out, let’s go back to this scenario I talked about, where people try to buy stocks at a low price and wait for the price to increase before selling it for a profit. Such profits are called capital gains. It is a one-time profit, and although the returns are great, so are the risks. For stock traders, capital gains are their bread and butter. It’s how they make money – identifying stocks that will go up in value in the near future. This is where all the complicated charts and algorithms come in, and it’s where you get that frenzied shouting on the trading floor of stock exchanges. This is not how we are going to make our money.

You will find that most people think only of capital gains when they think of stocks. Why is this? It’s because it is the most straightforward way to make money. It’s very self-explanatory: Buy low, sell high, earn the difference. However, this intuitive understanding of how people think they should make money in the stock market fails when actually applied to reality. The reason for this is that there are two parties to every transaction.

What do I mean by this? What I mean is that in every transaction of buying and selling, there is both a buyer and a seller. If you bought stock A, someone must have sold it to you. If you sold stock B, someone must have bought it from you. And if we assume that everyone in the stock market thinks the same way – they all want to make money by buying low and selling high, then who is going to sell stocks to them at low prices and buy it from them at high prices? Can you say for sure that you are better at outsmarting everyone else in the stock market on a consistent basis in order to turn a regular profit? Because that’s what everyone is trying to do: outsmart each other to make capital gains.

The honest answer is no. Even “financial” types like stockbrokers, fund managers and all these other financial analysts who call themselves experts can’t truthfully answer yes to the above question. Trying to outsmart the market is an impossible task, and an unnecessary one if our goal is primarily to make money.

So what’s this other mode of making money that I keep harping on? I’m talking about dividends.

What are dividends? To answer this question, we have to understand a little bit more about stocks and why companies want their stocks to be listed on the stock market in the first place. Consider the following scenario:

You have a company where you are the main guy running the show, and you put up all the capital to get the company up and running. This means you’re the main shareholder. But if you want more money to expand and you don’t want to bear all the risk yourself, what do you do? You find partners willing to invest in your company, allowing you to grow your business without taking out more from your own pocket.

The above sounds too good to be true, so what’s the catch? Well, when the time comes to take out the rewards gained for running the business, you’ll have to share the profit with these partners. That doesn’t seem so good a deal, until you realize that previously you might have been making $1,000 profit for just yourself, but now with a greatly expanded business you could be making $100,000 profit for five partners. That’s still $20,000 for you – a 20x increase in income.

If we take the above scenario and extrapolate it to a hundred, a thousand, tens of thousands of partners willing to invest in the company, then voila! That’s precisely what a listed company’s stock is doing. And while some of these partners buy the stock for capital gains, some of them will be buying it for the dividends: The sharing of the profits among the shareholders.

So, what are the perks of investing for dividends instead of capital gains?

  1. You don’t need to time the market (waiting for the “lowest” price before buying and the “highest” price before selling).
  2. You don’t need to monitor the market all the time. Need to work? Don’t want to spend all day staring at charts going up and down? Dividends are the way to go.
  3. Capital gains are one-off. Dividends come regularly (quarterly, half-yearly, or annually).
  4. You don’t need to understand complicated financial theories or concepts to know what is a good stock to buy for dividends.

Let me expand upon perk no. 4 by introducing you to one of the few financial measures you need to know: The dividend yield. If you buy a stock worth $1 and every year that stock gives you $0.01 in dividends, that means the dividend yield of the stock is 1%. Simple enough, right?

Now, you need to decide for yourself what an acceptable minimum dividend yield for yourself is. Once you’ve done that, it’s time to start looking for stocks that can provide you with your desired dividend yield. Unfortunately, it’s not so simple a matter as looking for stocks with the highest dividend yield and just plonking all your money into it. That is a sure way of getting burnt in the stock market.

Why is this so? In the stock market, there are good dividend stocks, and bad dividend stocks. How do we tell what is a good dividend stock?

There are three things:

  1. It must be a profitable business. As a rule, companies can only pay dividends out of profits it makes. The income statement of a company will depict the overall profit for the year that has just ended. Just zoom in on the net profit – that’s the final profit made after deducting all the expenses, taxes, and every other cost borne by the company in the running of its business.
  2. It must have a solid history of delivering on its promise to give out a certain X% of dividend yield. To do this, the company must be making sufficient positive cash flow.What is cash flow? Simply put, it’s the amount of actual cash a company makes or loses in a year. Remember, we want to make cold, hard cash. By looking at the cash flow statement of the company, we can see whether the company’s cash reserves have grown or diminished over the past year. This cash flow statement also shows dividends paid out for a certain year. Calculate the amount of dividends paid per share for each previous year, and you should be able to arrive at a conclusion about whether this company is one you want in your stock portfolio or not.
  3. It must provide an acceptable level of dividend yield. Owning a stock which says it made $1 billion in cash flow but refuses to pay a single cent of that out in dividends doesn’t help your bank account at all.

These are the basics of dividend investing. As you can see, it doesn’t require any seriously technical knowledge – just a basic understanding of figures and percentages will do. Always remember the golden rule: If your goal is to make money, then focus everything towards making money. Not choosing popular stocks. Not building a prestigious portfolio. Not looking for one-off deals that will make your fortune in one fell swoop.

Like I said before: Can you consistently beat the market? No. But you can make consistent profits if you carefully pick and choose good dividend stocks based on the three criteria I’ve laid out above.

In my next financial article, I hope to be able to show you guys some more pieces of advice regarding when and what to buy, and introduce you to how human nature is what causes most people to lose money in the market. However, if mastered correctly, human nature can be used to make consistent profits in the stock market instead! For now though, I’ll leave you with a nugget of wisdom by one of the greatest investors of all time:

The best time to buy is whenever you have money; and the best time to sell is never.

– Warren Buffett

Like this article? Please share it with your friends and family! If not, leave us a comment or some feedback for us to ponder over! The Thought Experiment is a growing site which thrives on ideas, and we want to be writing about issues that matter to you!

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