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While there isn’t a magic formula for making money in the stock market, there are few ways to put the odds in your favor. The key is to be realistic about your level of knowledge and the time you have available to devote to investing.
The simplest way to make money in the stock market is by investing passively with ETFs. This will allow you to earn the same return as an index of the stocks of the largest listed companies.
Over the last hundred years, the stock market has consistently outperformed other asset classes like bonds, real estate, and precious metals. At the same time, most investment funds have underperformed broad stock market indexes. When we talk about a broad stock market index, we are referring to indexes like the S&P500 which include the most valuable listed companies in a market.
So, investing in an ETF that tracks a market index means you earn the same return as the index so you are already ahead of most actively managed funds. It also means you are invested in the asset class that has consistently outperformed over the long term. Even relatively modest returns can compound substantially over a long enough period. ETFs are also much cheaper to own than almost any other type of financial product.
Improving the performance of a market ETF is possible but requires you to take a little more risk. One way to improve the performance of an ETF portfolio is by adding funds that track the faster-growing sectors like technology and consumer discretionary companies.
Buy and hold investing
The term passive investing is usually used to refer to investing in ETFs or index funds. Passive investing also implies holding the funds for a long time, without making any changes. Buy and hold investing is very similar.
Before passive investing emerged, the term buy and hold investing was used to refer to buying individual stocks and then holding them indefinitely. To a large extent, this is how Warren Buffet has made money, though there is a little more to what he does.
It’s more difficult to measure the effectiveness of buy and hold investing because its success or failure obviously depends on the stocks that are selected. But there is a big advantage to this strategy. Investors often sabotage their own performance by buying and selling stocks and trying to time the market. In many cases they would earn more by simply buying and holding stocks, assuming they don’t start out with terrible stock picks. The solution is to own quite a few different stocks and to stick to stocks with good business models, competitive advantage, and strong leadership.
Advanced ways to make money in the stock market
Passive investing is by no means the only way to make money from stocks or the best way. There are a lot of more complex methods, but they do require more time and knowledge, and typically more risk. Here are some of the most common methods of investing (and in some cases trading).
Mutual funds and actively managed ETFs
While the majority of actively managed funds – both ETFs ad mutual funds – don’t outperform the market when costs are taken into account, some do. A lot of very successful investors move money between different funds to try to beat the market. This does require a lot of research though.
The temptation is to chase performance by investing in the funds that have performed well in the recent past. This often backfires though, and investors end up buying high and selling low. The trick is to find the funds that are likely to perform well in the future, regardless of past performance.
A value investor buys a stock if they believe the price a share is trading at is substantially below its intrinsic value. This is the value of the company’s assets divided by the number of shares it has issued and also represents the liquidation value of the company.
Buying a share below its value gives you a margin of safety, and you may be able to make a profit without the company growing at all.
So, you have a limited downside, with a large potential upside if the share price recovers. Value investing requires a very good understanding of company accounts and financial statements.
Growth investing is all about profit growth and the potential for profit growth. For a company to increase its profits, it must either grow sales, or it must expand its profit margin. Sales growth is easiest when the entire market for its product is growing – otherwise, the company must increase its market share. Margin growth often results from the effect of economies of scale, as fixed costs grow at a slower rate than sales.
The challenge for investors is the price of growth stocks usually reflects a certain amount of future growth. If growth disappoints in the future, the share price may appear excessively expensive and fall. Nevertheless, growth investing has been remarkably successful over the last two decades, particularly in the tech sector, which includes companies like Apple, Amazon, and Facebook. The other sector with good growth companies is the consumer discretionary sector, with the likes of Starbucks and Nike.
If you are more interested in building an income stream than in capital growth, dividend investing is another option. Companies pay dividends to distribute earnings to their shareholders. The companies that pay dividends tend to be more mature and to have good profit margins.
There’s often a temptation to buy the stocks with the highest dividend yields. But the most important factor is actually the sustainability of the dividend. If a company can’t keep dividend payments up, the share price will probably collapse, and you’ll lose a lot more than your dividend. The best dividend stocks are those that can easily afford to keep raising their dividends.
Yes, you can make money when stock prices fall. You can do this by short selling which involves borrowing shares (for which you pay a fee) and selling them. When the share price falls, you can then buy the shares back and return them to the lender.
Shorting stocks is an advanced strategy and needs to be approached with caution. If too many traders’ short stock, there’s a high likely hood of the price being ‘squeezed’ higher. Remember that for a short position, the potential loss is unlimited.
Short selling allows long and short positions to be combined. This means you can buy a stock you expect to perform well, and short sell a stock you expect to underperform. The advantage of this strategy is that the position is hedged against a general market correction.
Each of the investing approaches listed here requires a different level of knowledge, skill, risk appetite, time, and patience. Finding the right approach means finding an investment style that fits your level of knowledge, personality, schedule, and financial situation. Passive investing is the best place to start.