Nick Sciple: Hey, I’m fool.com editor
Nick Sciple, and on this episode of FAQ, we’re answering the question you’ve all been asking:
how do you make money in the stock market? People invest to make money, plain and simple.
Except in special circumstances, like shorting a stock, investors buy a stock with the hopes
that it will increase in value, allowing him or her to sell the shares later at a higher
price and pocket the difference as profits. But how do we know a stock is going to go
up before we buy it? In the short term, stocks go up or down for an endless number of reasons
— from military conflict and news releases all the way down to individual tweets. However,
there’s only one reason a stock’s price increases or decreases over the long term: to match
the value of a company’s assets and cash flows. As Ben Graham famously said, “In the short run,
the market is a voting machine, vacillating based on the news of the day. But in the
long run, it’s a weighing machine, measuring the actual value of a business.”
Now that we know why a stock’s value increases over the long term, we can answer how to make
money in the stock market. There are two ways to make money in the stock market. You can
either buy a company for less than it’s worth, or you can buy a company at fair value and
hold it as it continues to grow over time. Let’s look at each of these in turn.
Imagine I offered to trade you a $1,000 car for $500. Would you take it? Most of you probably
said yes. Free $500, right? Now, you can take that car, and with patience and effort, find
a buyer for the car’s full value. Maybe the seller didn’t want to put in that effort,
didn’t know what the car was really worth, or, for whatever reason, they needed the car
gone quick, and they decided to sell it to you for that reason. This same
thing often happens in the stock market. A stock falls out of favor, whether
due to bad news around a company, market volatility, or really a number of other reasons, and its
price falls below what the company would be worth to a reasonable purchaser based on its
earnings and assets. Intelligent investors can take advantage of these opportunities
to purchase shares of a company for less than it’s worth, and just like with the car,
sell the shares for a tidy profit once the market realizes its mistake. Also like the car,
it may take a long time to find a buyer, because markets can remain irrational for a long period
of time. However, this strategy has been among the most successful in the history of investing.
This approach — buying shares of companies for less than the resale value of the company
as a whole — is known as value investing. It’s been used for decades by famous investors
like Warren Buffett and Benjamin Graham to build incredible wealth.
But that’s not the only way to make money in the stock market. Now, imagine I offered
to sell you a grocery store in a small town with only 100 people for its fair value.
This grocery store is the only one in town. Everyone in town shops there for all their food.
And it’s profitable. You know that in five years, a new factory is going to be built in the
town that’s going to bring 500 new people to the area, bringing the total population
up to 600 people. Would you take my offer to sell you the grocery store for fair value?
Of course you would! You know that in five years, the grocery store will have six times
as many customers as it does today. With a larger customer base, it should pull in even
more money, making the store look extremely undervalued in five years. This same
phenomenon often occurs in the stock market. For example, when Amazon went public
in 1997, it enjoyed a market value of around $450 million. However, over the ensuing 20 years,
as consumer preferences shifted towards e-commerce and the company wrangled emerging
trends like cloud computing, streaming games, and advertising, Amazon’s earnings have skyrocketed
by 34,000%, and it now holds a market value of over three-quarters of a trillion dollars.
For investors who were patient and confident enough to hold the company for the long term,
through 50%-plus sell-offs, competitive risks, and probably some boredom, Amazon has provided
life-changing returns. This investing style — buying companies with promise for future
growth and holding for the long term to realize the benefits of that growth — is known as
growth investing, and it’s a strategy that’s been used by famous investors like Philip Fisher
and The Motley Fool’s own Gardner Brothers to great success. Whether you
decide to invest for value or growth, or you shoot for some of both, successful
investing requires knowledge and patience. Knowledge of what a business is worth,
and where a company has opportunities for growth in the future. Patience to wade through many
investment opportunities until you find one where what you know about a company’s long-term
worth and what the market thinks it’s worth are out of sync; and finally, the patience
to wait for the market to recognize that worth. However, if you can master the patience
and discipline it takes to stick to either of these investing approaches, you’ll be able
to drive life-changing returns for yourself and your family over the long term.
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