In Part I of this series we discussed the difference between a Smart Stock Investor and a speculator as well as first steps for a newbie investor interested in learning more about the stock market.
In this article I will explain how Smart Stock Investing can lead to a substantial increase of your annual income as well as five tips on how to pick stocks that will add to your income in the long term.
If you’re like the typical entry level college student you probably make somewhere around $30,000 to $35,000 a year pre tax. Let’s assume an approximate $30,000 annual salary with an after tax income of around $2000/month.
$2000
- $900 for rent
- $600 for food and entertainment
- $100 for school loans
_____________________________
$400 in savings per month
Assuming the above figures for expenses, you would save approximately $400/month, which is a 20% monthly savings rate. In one year that will add up to $4800. Not bad!
Note: the more you save, the easier it is to recieve a higher return from your investment.
For example, let’s say our goal is to have an annual gain of $3,000, which is 10% of $30,000. If you save $4,800 in your first year, you would need a 63% annual return on investment in order to hit the $3,000 goal. While possible, it’s very, very difficult.
However, after three years of savings you might have close to $15,000. $3,000 of $15,000 is only 20%; while still high, it is much more realistic than 63% returns. After five years, at the same savings rate, assuming no increase in salary (which isn’t realistic), you would have nearly $25,000 saved. $3,000 of $25,000 is approximately 12%.
12% is a very achievable figure and it would also make for a very nice raise.
Choosing businesses to invest in that would yield an overall return of 12% is not easy. It’s more probable to pick a few good companies that will yield an average annual gain of around 10-12%. However, it is important to remember that like any kind of an investment, there is no guarantee everything will go as planned. In any given year, a company that is poised to achieve big gains can suddenly find themselves hit with an unexpected natural disaster or other calamity that would affect operations and impact their bottom line.
However, the likelihood of hitting the 12% target, while above average, is very doable if you pick businesses you understand, are profitable and growing.
Tip #1: Pick Less Expensive Stocks
Most investing gurus advise people to put their money in reliable, blue chip stocks such as GE or Walmart. This is good, sound advice for someone who has dependents and is looking to build not only a nest egg, but also a college fund for their children. People who are in the mid stage of their life and careers can’t afford to lose their hard earned savings and thus it makes sense to invest in stocks that would seem less prone to fluctuation.
If you’re following the stock market now, you may notice that even blue chip stocks are taking a beating. So this advice doesn’t always apply even for larger companies. That’s why it’s important to have a thorough checklist before making a decision to buy.
For the young investor, with limited cash available to invest, it’s better to buy more shares of less expensive stocks than a few shares of an expensive one.
Let’s say company A’s price per share is $10 and company B’s price per share is $50.
If you only have $1,000 to invest, that would give you 100 shares of company A and only 20 shares of company B.
If company A’s price per share moves from $10 to $11, your gain is (100 * $1 ) = $100.
While if company B’s price per share goes to $51, your gain would be (20 * $1 ) = $20.
The more shares you own, the more you will gain when the price goes up.
Though remember, if the stock price’s go down the same also holds true. The more stocks you own the more you will stand to lose.
Tip #2: Pick Companies Whose Products and Services You Understand
I mentioned this in Part I of this series, but it’s so important that I want to make the point again.
If you don’t know anything about technology companies, don’t buy technology companies. This is a principle that Buffet stands by and I do as well. The more you know about a company, the easier it is for you to tell whether the company will do well or not. If you don’t know how Google makes money, does it really make sense to invest in Google? Even if everyone around you says it’s a good investment?
Every business is selling one of two things: a product or a service. If you understand the company’s product or service well, or even better, if you regularly buy or use their product or service, then you are in a stronger position to make judgments about the future earning potential of the company.
For example, I once thought about investing in a number of clothing companies such as Abercrombie and Aeropostale because I heard that they were doing well. However, after some deliberation, I realized that I didn’t know enough about their products nor was a really willing to do the research necessary to get a good sense of how the company was faring in terms of their competition.
Remember: A company must sell their product or service in order to make a profit.
Your goal is to understand well not only the company’s product, but how well and to whom they will sell to.
Tip #3: Pick Companies With a Positive Cash Flow to Debt Ratio
Generally, it’s best to avoid company’s with a low cash flow to debt ratio , which is simply the amount of cash coming in divided by the amount of debt that the company has to pay off.
In order for a company to grow, it has a few options: it can sell more stock in the company (equity financing), borrow money (debt financing), or they can reinvest their profits if any. Company’s that have more debt than cash coming in tend to be less able to adapt to changing business enviornments. This can be a hindrance to growth.
Company’s that have positive cash flow demonstrate that they are able to generate working capital which they can reinvest or possibly hand out to shareholders as dividends.
Tip #4: Pick Companies Whosel Products or Services Are Relatively Price Inelastic
A product is price inelastic if its demand does not change significantly relative to a change in price. Company’s that sell products that are relatively price inelastic tend to fare better regardless of the economic climate.
Products that are relatively price inelastic tend to have no close substitutes. A good example is crude oil, even though the price is shooting through the roof, people still need to buy gas for their cars to get around.
However, a common household staple such as chicken is relatively price elastic. If chicken ever got too expensive, people could switch to eating more beef, pork or fish.
Tip #5: Pick Companies That Pay Out High Yielding Dividends
Companies that pay out dividends are a great way to build long term wealth. A good example is GE, which is right now yielding a 4.53% dividend. While no company has the obligation to pay out a dividend, GE has been paying out their dividend for over a hundred years and their dividend has been increasing for the last three decades.
To calculate how much in dividends you will get paid just multiply the dividend amount by the number of shares you own. GE’s current dividend pay out is 31 cents a share per quarter. So if I own 100 shares, I would get paid 31 dollars per quarter.
Dividends are usually paid quarterly or biannualy.
Dividends are nice because you the money goes directly into your brokerage account, which you can reinvest or use as you please. As you grow your positions in dividend paying companies, your dividend income will grow as well.
While there’s no exact formula on how best to invest your money, if you follow the tips mentioned above, you will keep your focus on companies that will add to your income and savings rather than diminsh it. Remember that investing is not a get rich quick scheme, but a long term strategy for wealth building.
In How to Get Rich With Patience Part II: The Fast Road to Seven Figures , I emphasized the importance of investing in growing and profitable companies for rapid wealth building; stocks investing is essentially business investing; each stock you buy is a piece of a business. If you invest well you can substantially increase your wealth in the long run.
For more information I would check out The Motley Fool as they have a ton of great information on how to evaluate businesses and to make good long term stock investments.
Related Articles
If you liked this post, make sure to subscribe to my feed via RSS , or via e-mail.
If you found this post helpful, please consider leaving a donation to support this site!
0 responses so far ↓
There are no comments yet...Kick things off by filling out the form below.