3 Things You Need to Do to Make Money Buying Stocks
We have a tendency to make investing too complicated. When it gets too complicated, it can get risky. If you’re investing for the long-term — and that’s really the only way to go — there’s no reason to take on unnecessary risk.
If you have seen success in the recent bull market, don’t be greedy. I have been there before. And I failed to follow one of investing’s most important tenets — it’s never a bad idea to take profits. If you’re sitting on profits, yet still want to be in stocks, consider the following strategy. While it’s not possible to eliminate risk, if you have time on your side and practice patience, doing these three things can limit stress and produce meaningful success over time.
Buy Dividend-Paying Stocks
Before I adopted this relatively strict investment strategy, I got off track because I had too many stocks to chose from. Sounds basic, but think about it. Across global exchanges, you have roughly 630,000 choices. To determine which stocks to buy, you need to narrow the field. This takes specialized knowledge most of us don’t have. And, even if we have some, it’s difficult to pull it all together.
Which metrics do we use to decide on one stock versus another? Or are we simply using the buy what you know strategy? If so, isn’t this a rather arbitrary way to make the important decision of where to invest your money? Flipping the logic, with too many stocks to choose from, you might miss out on names you don’t know simply because they’re not on your personal radar.
You’re not always going to get it right, but it’s easier to whittle the universe of stocks down to something more manageable if you focus on a subarea of stocks. The easiest subarea of stocks functions like a subculture. Investors who favor stocks that pay dividends call themselves dividend growth investors. They refer to their investing style as DGI (dividend growth investing).
It’s a straightforward way to make the vast universe of stocks smaller. It also puts companies in front of you that you might not have otherwise heard of or discovered via a broader research process.
Approximately 3,000 stocks pay dividends. While the number changes somewhat frequently, as of September 2020, we classify 65 stocks as dividend aristocrats. A stock becomes a dividend aristocrat when it has increased the size of its dividend for at least 25 consecutive years. You can broaden that out a bit by looking at strong companies with a shorter history of dividend increases. Stocks such as Apple and Starbucks.
It’s easy to understand what a dividend is. When a company pays a dividend it returns a share of its profits to shareholders via a dividend payment. Companies usually make this payment quarterly, however roughly 50 or so of the 3,000 pay monthly dividends. The amount of dividend income you receive depends on how many shares you own.
Let’s say a company pays an annual dividend of $1.00 per share. If you own 100 shares of the company’s stock, you’ll receive $100 in dividend income each year. Paid out quarterly, you get $25 every three months.
Here’s where it gets interesting.
Reinvest Your Dividend Payments
You can take your $25 in dividend income each quarter and do whatever you’d like with it. It’s effectively cash in your pocket. However, you give yourself a better chance of making money, if you elect to reinvest your dividend payments. Each time you receive that $25 payment, you can use it to buy more shares of the company’s stock.
Here’s where it gets not only interesting, but beautiful.
In this example, I keep everything static. No stock price increase. No dividend increase. You own 100 shares of a $25 stock. You do not make any new purchases. You reinvest all dividends. By the end of year five of owning this hypothetical stock, your position size increased to 122.02 shares simply by reinvesting your quarterly dividends. That’s because each dividend reinvestment increases your position size leading to a slightly larger dividend payment to reinvest in each subsequent quarter.
If this doesn’t highlight the power of this strategy and compounding income, I’m not sure what does. A $2,500 initial investment becomes $3,050.48 by the end of year five — a 22% increase — because of nothing other than the power of dividend reinvestment.
Let’s add another variable to the mix. This hypothetical company increases its dividend by 3% each year. Everything else remains the same.
By year five, that $1.00 annual dividend increases to a $1.13 annual dividend. And, instead of a 22% return, you’re sitting on a 23.5% on-paper gain.
Here’s where it gets even more interesting and beautiful.
Use Free Cash Flow to Buy the Same Stocks Over and Over Again
Your individual free cash flow is just a fancy way to refer to your disposable or discretionary income. It’s the money you have left to spend after you pay your monthly expenses. Spend as much of it as you can on more dividend-paying stocks.
Let’s see what happens when we add a $50 recurring monthly investment with new money to our hypothetical example.
You’ll have $6,366.67 at the end of five years. Of course, this isn’t a perfect example because we’re using a static stock price. You’ll buy more shares — via both dividend reinvestment and with new money — when the stock price goes lower. You’ll buy fewer shares when the stock price trends higher. I kept it simple to illustrate the general power of DGI.
In any event, these three points provide a clear path to make money investing in stocks.