It’s great that you’re interested in the stock market. Obviously, everyone would like to strike it rich once they start committing money to their trading accounts. Before we delve into how to make money on stocks, it’s better to first explain why people are stock trading in the first place, as this will help set your goals.
Reasons people trade shares
To generate profit
Stock prices tend to appreciate every time the company performs well financially. Say for instance, you bought 100 IBM shares in 2016 at $128 per share. If you happened to hold the stock until March 2017, when the price was up to $180, you would generate a 40% profit upon selling.
To earn income from dividends
A large number of publicly listed companies pay dividends every quarter. Normally, this happens after the company’s financials post an improvement over the given period. Depending on the number of shares held, investors can earn a handsome income on a quarterly basis from the dividend payments.
To beat inflation
Inflation might be a necessary condition for economic growth, but its effect is quite the opposite for your income. Effectively, higher inflation degrades income. Investing in stocks, however, helps you to beat inflation if your returns are healthy enough.
Historically, stock prices have shown the tendency to rise. As such, the stock market is an ideal platform to commit your savings for long-term commitments. This makes it ideal for retirement savings.
Two ways to make money on stocks
You can probably guess the answer given the above, but just so we’re clear, how do people make money on stocks? People make money investing in stocks in two major ways. First, through increased share price and second, through dividends.
Higher share price
In our IBM example earlier, we assumed you bought 100 IBM shares in 2016 at $128 per share. IBM then experienced growth in its profits due to prudent management and business expansion. As a result, the price of the stock appreciated to $180 in March 2017, which marks a 40% growth in value. In 2016, you spent $12,800 ($128 x 100) to acquire the stake in IBM, but if you went ahead to relinquish the stake in March 2017, you would be 40% richer i.e., $18,000 ($180 x 100).
An important principle that investors must acknowledge is that the value of a stock is directly proportional to the profits that the underlying company generates. Therefore, an underperforming company might not be ideal for anyone interested in generating income. The same rings true for companies that offer dividends.
Usually, dividends represent profits generated over a certain period and are distributed across the company’s shareholders based on the number of shares held. As such, without profits, there are no dividends. Once a company declares a dividend payment, it sets the price and the date at which it will honour the obligation. Companies pay dividends to the people who own stocks in the form of cash or reinvestment through offering more shares.
It’s important to remember that the stock market involves risks, just like most other investments. Unlike other capital markets like bonds and treasuries, the risk premium in the stock market is higher. It is important to acknowledge that you could lose money. We recommend reading the full range of stock investing guides from Invezz before parting with your money.