The stock market can be volatile, even dangerous. But used correctly, it’s a powerful wealth-building tool that has stood the test of time, including global depressions, wild fluctuations in interest rates, and even world wars. Those who use this tool properly, even following just a few simple guidelines, can build massive amounts of wealth.
What it really takes is an understanding of the common sense and patience involved to make those returns happen.
Let’s take a look in detail about how that works, and how anyone can get rich from stocks.
The Magic of Compounding
Investing ultimately comes down to creating the power to compound wealth. Wealth compounding occurs when your money makes money… and then that larger pile of money is invested in ways that make even more money for you.
Known as compound interest, it’s also known as the “snowball” effect, when a snowball rolled down a hill picks up more and more snow and gets larger and larger.
Here’s how it works in practice:
Let’s say you have $10,000 to invest at the age of 20 from years of lemonade stands, mowing lawns, and mostly getting cash from relatives on your birthdays, plus a part-time job as a teenager. You put the entire kit and caboodle into the stock market for 50 years, and let’s say over that time, you put it in a growth fund that manages to make an even 10 percent per year.
Sure, the real world is a bit “lumpier” than that, as stocks may fall 10 percent one year, than rise 30 percent the next. But a 10 percent return is achievable with a bit of risk tolerance.
What happens to your money?
In the first year, your $10,000 makes $1,000, or 10 percent. Now you have $11,000 to invest. That $11,000 earns 10 percent, which comes to $1,100. Just by keeping that money in the market, your money has started making money for you.
Sure, an extra $100 may not sound like much. But over time, as wealth compounding takes hold, amazing things happen.
Fast forward 50 years, and a mere $10,000 one-time investment, making just 10 percent per year, can grow to over $1.1 million dollars.
$1,173,908.53, to be exact.
That’s an amazing nest egg for a one-time investment when you’re young, allowing time to produce substantial gains for you.
As you can see, there’s a huge difference between being invested for 50 years and 40 years. Even going from $10,000 to $100,000 takes over 20 years, or 40 percent of the time.
So the key lesson to getting wealthy? Start compounding early and let the process continue as long as possible!
But it gets even better. If this 20-year old started with $10,000 and managed to add just $250 each month over the same period, the return more than quadruples to $4,665,634.12. So don’t be afraid to start investing today, with an eye towards adding more money in when you get the chance.
Become a Millionaire at Any Income Level
Compound wealth is so powerful that anyone can become a millionaire, at just about any level. It just takes time, and the willingness to invest in blue-chip companies that are unlikely to go bankrupt. That’s it.
In 2015, Ron Read, a Battleboro, Vermont janitor, passed away at 92. He wasn’t the kind of guy a stock advisor would seek out, given his occupation and his down-to-earth style of dressing.
So naturally it was a bit of a shock to the community when his estate donated a whopping $4.8 million to the local hospital, and $1.2 million to the local library.
How did a 92-year old who worked as a gas station attendant, and later a janitor (part-time) manage to make so much money? By buying and holding great companies for a long period of time.
He kept most of his money in stocks rather than a savings account, and let wealth compounding do the trick. He wasn’t a huge tech stock investor, or penny stock investor either, focusing on companies he knew and understood like Procter & Gamble (PG), JP Morgan Chase (JPM), and AT&T (T) among others.
That’s the power of wealth compounding. Chances are if Read had died just 10 years earlier, at 82, he would have been worth less than half what he was at 92 thanks to the wealth-compounding process.
It also helps that Read was known for his frugal ways, such as parking his car a distance away from places where there was free parking instead of paid parking, and rarely going out to expensive restaurants. But he lived his life on his own terms, and found financial freedom as a result.
By living below his means, no matter how modest, and investing in great companies, he was able to amass a large fortune.
Become a Billionaire With High Enough Returns and a Long Enough Timeframe
If you’re actually trying to make money, this same strategy can be used to become a billionaire. That’s what happened to Warren Buffett when he was in his 50’s, through his astute investments and partnership agreements when he was younger, built from knowledge and experience, including time working on Wall Street.
By borrowing other people’s money and then investing in value names, Buffett was able to beat the stock market in the 1950’s and 1960’s, eventually becoming CEO and a large shareholder at Berkshire Hathaway (BRK-A), which he has then used as an investment vehicle to buy common stocks or entire companies outright.
The wealth compounding power has slowed a bit in recent years as the company has hit a massive size, but as Buffett approaches 90, his net worth has risen to over $78 billion.
So the power of compounding isn’t merely a function of your total percentage return. The true power is in getting a good return and having enough time for it to play out. Do that, and you’ll have enough money to do whatever you wish.
How to Grow Rich Investing in Stocks
We’ve already seen that investing is mostly about making a few good choices and giving time for them to play out. It doesn’t matter if you’re a janitor or Warren Buffett—or anywhere in between. Time, patience, and a willingness to look for quality companies that can grow over time rather than an attractive story now are all that it takes.
Of course, there are plenty of ways to achieve those results. Warren Buffett likes to talk about holding some stocks forever—and a few he’s held for decades. But the Berkshire Hathaway portfolio often makes some changes, and many investors may want to take profits in a trade that’s done well to fund a new opportunity that’s presented itself.
This is known as active investing.
From retail day traders to hedge fund managers, the world is awash in active investors engaged in stock trading. As trading fees have been dropped to zero, the average holding period of a stock used to be measured in years in the 1950’s, today it’s measured in weeks. And some traders barely hold stocks for fractions of a second, looking to make a small profit on fractions of a penny, a practice known as flash trading or high frequency trading.
For now, let’s think of active investing as any trade held for less than one year, the cutoff mark between paying short-term capital gains taxes on a trade and long-term capital gains taxes on a trade.
Active investors are looking for stocks likely to have big moves quickly, and active trading tends to focus around those names. While this stock picking can be a profitable strategy, finding these opportunities and looking to profit from them can be a full-time job, and not everyone can engage in day trading full-time.
Active investing can create higher returns compared to passive investing, but most long-term wealth building happens over years of being in the same stock, not weeks. Taking an active approach can lead to losses that impair the compounding process.
Passive investing is focused less on finding individual stocks likely to outperform the market over the next year and repeating over time, and more about buying entire markets and creating a diversified portfolio of different stocks, usually via mutual funds or ETFs such as an index fund.
With this approach, an investor is likely to perform about in line with the market over the long-term, giving up outperformance but also likely to avoid significantly underperforming the overall stock market as many individual investors are likely to do. In short, it means seeking steady investment returns.
That’s a fair tradeoff, as it means that an investor is likely to avoid being too heavily invested in a stock or sector that’s out of favor with the market, while also getting exposure to the market’s top performers. And this kind of investing tends to be long-term, which is tax-efficient as well, as capital gains taxes are deferred until a sale (which may not happen in an investor’s lifetime).
Long-Term Investing is Key
No matter which investment strategy you choose, investors need to think about how their choices will work over the long term.
An active investor may want to invest in a company likely to show high gains in the next year or so, perhaps as earnings rebound or the company releases a hot new product that will lead to a surge in shares.
But longer-term, those profits will need to be invested in companies that are capable of growing their wealth over time. Companies that can continue growing over the long term, even if it’s at a slower rate than the fast-growing companies of today, are likely to be the ones that continue to compound wealth.
That’s why investors like Ron Read and Warren Buffett have money in well-known, big-name banks, consumer goods companies, and even industrials and energy.
While they may not make the list of growth names year-in and year-out, they tend to do consistently well over time, which makes it substantially easier to grow wealth than investing in bonds or real estate.
Picking Stocks of Good Companies
Why do most investors fail to achieve these kinds of wealth compounding goals? It usually happens because they become traders, thinking in the short-term. In the short-term, anything can happen.
A great company can see its shares dive. A story stock with no real earnings prospects behind it can rise five-fold. You’re just not putting the odds of success on your side with the short term; it’s simply too random.
What does matter is investing in companies that can withstand the test of time. In good markets and bad, these companies can continue to fend off competitors and gain market share, while avoiding levels of debt that can get a company into trouble.
That’s why it’s no surprise that some of the best companies of the past few decades have been tech names, which have had to constantly innovate and find new products to keep customers happy. Companies that can grow their earnings consistently over time, or can sport high profit margins, are strong contenders to buy for long-term wealth compounding.
But the best criteria? It’s dividends.
Investing in Dividend-Paying Companies
From Ron Read to Warren Buffett, one secret to growing your wealth is to find dividend-paying companies. Why? Because mature companies with limited growth prospects can either use their cash flow to try and grow another way—which often fails, or they can give that cash to their shareholders. When they give that cash to shareholders, the shareholders can use that money to pay for current expenses, or reinvest it.
Over time, nearly half an investor’s return can come from reinvested dividends. So it pays to start dividend investing young, and to use the income to fund additional trades. In a market selloff, that may mean buying more shares of companies you already own at a discounted price, but it may also mean adding new positions when events warrant.
Think about it this way: If stocks return 7 percent on average, an investor who’s getting a 3 percent dividend yield only needs a 4 percent profit in a given year to match the market. A great dividend stock can do better than that over time, meaning the dividend provides an extra return besides the ability to add cash on a regular basis. That’s why great investors with a long-term focus buy dividend-paying companies. There are just too many great reasons for doing so.
Dividends tend to be tax-efficient too, given their lowly 15 percent tax rate. That’s a rate that doesn’t kick in for a while either, as most investors can defer a substantial level of dividends in their investment portfolio. Simply put, Uncle Sam wants investors in the stock market for the long haul, getting passive income along the way, and the tax rates on dividends show it.
Can you Get Rich By Trading the Stock Market?
Yes, you can.
Not only can you get rich trading stocks, and reach financial independence doing so, there are several ways to do so.
An active investor can look for undervalued opportunities likely to outperform in the short-term, and continue to compound wealth quickly that way. Or an investor can take a passive approach that seeks to mimic the market’s long-term performance in a tax and commission-efficient way.
Investors can even take a blended approach, using some of their wealth to passively invest in the market while actively trading on a few opportunities that may pop up from time to time.
No matter how investors approach the stock market, finding a consistently profitable strategy, and applying it over time—think decades, not weeks—will lead to massive wealth creation. The longer an investor is able to defer pulling money out of the market, the more likely they’ll end up a millionaire with relatively minimal results.