Hey! Welcome to this post where you are going to learn exactly “What is the Stock Market” and “How can you make money in it!”. We all want to invest our money and make it grow, but we are very hesitant to put our money in something that we don’t understand, right? I guess you probably have your money in a savings account because you understand what it does? You put your money there and the bank pay you a minuscule % for holding your money!
Maybe you’ve heard about how great is investing in real state, and that’s something that we all can understand, you can buy a house, rent it, make money from rent and later sell it for a gain, easy to understand! BUT, what on earth is the stock market?
I promise you that by the end of this post you will know how I and others make money from the stock market and I will explain all of it using real life language, so sit tight and be excited, I will unveil the secret to you!
What is the Stock Market?
This is easy, trust me (stop shaking your head!). Lets say that you own a lemonade stand, and your business is doing good and you make $100 profit every month after expenses, this means that after 12 months or a year, you make $1200 in profit. So far so good right? But you are a talented and ambitious lemonade stand owner who knows for a fact, that the only thing keeping your profits from growing faster, is that you don’t have more lemonade stands, and that you would have to hire people to run them.
This is the situation that many companies face, they need money to grow their business and those companies have 2 options to get the money to grow their business. Option 1, you go to the bank and ask for a loan and pay quite some money on interest rates, OR, option 2, you look for investors who are interested in your business and form a partnership.
Your company becomes a Stock Market Traded Company – Lemonade Stand INC is born
If you decide to do option 2, you will require a certified accountant to verify your financial information, just to make sure that you are actually making $1,200 every year like you say, and since you are doing this via the stock market, your financial information becomes public, that way anyone who invest in your lemonade stand knows exactly how is doing? (You can google any company that is on the stock market and find their financial info, you can try Apple if you want).
So, how does that work? Simple! You have to break your lemonade stand in small portions called shares, to keep it simple, you break your business in 1000 shares, and since you want to have the majority of the shares, you keep 700 shares and make 300 shares available to investors.
How much is each share worth?
How much is each share valued? To answer that we have to value your entire lemonade stand business, let’s say that is worth $5,000. Why so much? Well, you have some assets (Your Stand), materials (Juice Extractor) and Inventory (Lemons!), all that plus your yearly earnings gives a total valuation of $5,000. Well, if your business is worth $5,000 and have a total of 1,000 shares, if you divide business worth by shares it gives you $5 per share. Simple enough right? I know you are keeping up! (In Stock Market terms, Business Worth is called Market Capitalization).
Congratulations, you officially have a stock market traded lemonade stand, each share is worth $5 with 300 shares available to the public and anyone can buy and sell (trade) those shares. But wait a minute, why would anyone would like to own a share of your lemonade stand?
Why would anyone invest in Lemonade Stand INC?
If I’m about to invest in your business, I would like to know how fast are your growing your profit, let’s say that 3 years ago you made $900, 2 years ago $990, last year $1,100 and this year you made $1,200. If you do the math, it means that your profit is growing 10% each year. If nothing changes in 10 years, as in, you decide just to keep your simple lemonade stand a maybe build a couple more, when you reach your year #10, you will be making $2830 on that year in profit. Not bad eh? (I increased $1,200 by 10%, 10 times)
But remember when I said that you are an ambitious lemonade stand entrepreneur? Maybe you have a great plan, you will make an app so people can order a lemonade in advance, with them loyalty points and have a franchise of lemonade stands, but you won’t stop there, you will add new beverages and special promotions! Isn’t that exciting?
Well, if I (the investor) know all that, I can say that if everything stays the same, in 10 years each share is going to be worth $12 ($5 per share growing at 10% per year), which is double my money, but since I know that you have big big plans, I can say that your profit will grow at 25% each year. Why is that good?
Well, since I know that you have a solid business, great plans, loyal customers and nobody can take your business down, I’m more than happy to buy each share at $5 since I can expect it to be worth a lot more in 10 years. How much? Growing the profit at 25% each year for 10 years gives a final share price of $38. That’s almost 8 times my initial investment in 10 years? Hey, sign me in!
How do you know if 10% or more is a good return? Using the Rule of 72, with a return of 10%, it will take you 7.2 years to double your money, at 25% return almost 3 years! How does that compares to your savings account at maybe 1% return? Well, it will take you 72 years to double your money with your savings account, Ouch!
Rule of 72: Divide 72 by the return rate in order to calculate how many years it will take to double your investment.
Bad news hits your lemonade stand
We are at year 5 of your lemonade stand business and suddenly boom, bad news hits you. Someone bought a bad batch of lemons and gave bad lemonade to some customers in many locations. The newspaper goes crazy, “Lemonade Stand INC is rotten”, “Lemonade Stand INC? Run away and drink lemonade somewhere else”. In paper, your business is now worth $20,000 and with 1,000 shares, it means that each share is worth $20. But with that terrible news, investors start going into panic mode, selling all their shares, making the price drops from $20 to $15, that’s almost a 25% loss. What would you do now?
Your perspective (The Owner): You know is a bad batch, you only have to get rid of those bad lemons, give a public statement saying that you are truly sorry, that you will improve your quality procedures and promise that this will never happen again, and make a free lemonade day to apologize to your loyal customers. Guess what? your share price still drop from $20 to $15, but you know that in a couple of months business will be back to usual.
Recommended post: 5 Things to do during a stock market crash
Amateur vs Smart Investors – Should I sell or buy more shares?
The Market perspective (amateur investors): OMG! This is the end of Lemonade Stand INC, I have to sell all of my shares, the business will go bankrupt, I have to get rid of it before I lose more money. Run while you can! This is the end!… And these investors end up selling their shares with a 25% loss. Why? Because they fail to see the big picture.
Smart Investors perspective: Wow… Ok, so the problem is just a bad batch of lemons? Okay, that can be solved in 3 months. Will those customers go to another lemonade beverage vendor? No, only Lemonade Stand INC have the pre-order phone app, loyalty program and loyal customers, this is only a bump. How much is the business worth? $20 a share? Oh! Amazing investing opportunity, I will buy as many shares I can at $15 because the business is currently undervalued!
Recommended post: How to become a badass investor in 5 steps
The share price keeps tanking – What to do?
What happens if I buy shares at $15 and still drops to $10? Should I sell my shares? Well, if I know for a fact that Lemonade Stand INC is a solid, strong company that will be still in business in the next 10 years and profits are growing at 25% year to year, well, I will buy more shares if I can. Why? Because once the dust settles, the amateur investors come back to sense and understand that the company is actually worth $20 it will be too late (for them) because smart investor would have already bought the stock at $10 and double their money once it gets back to $20 (real value), but guess what? That share price will keep growing year to year!
And that my friends, that’s a very broad picture of how the stock market works and how you can make money from it, especially when amateur investors start panicking presenting you with amazing buying opportunities, because who doesn’t want to buy a business that is worth $20 per share for $10 per share.
And right now, you might be asking, “But Derek, does that REALLY happens?”, YEAH! It does, every day they the market will present to you Companies that are being sold at below their value, and others above their value. You only need to do your research and understand which one is undervalued and which one is overvalued.
Did you noticed that I was always talking about a 10 year time frame? That’s because we as stock market investors invest in companies that are strong and that will be still growing and in business in the next 10 years. Nobody knows what can happen tomorrow or the next year, but if I know that I can get a return of 5 or 10 times my money in 10 years because the company is growing at that pace, then I will hold my investments through thick and thin because I only focus on the long-term, big picture, I don’t mind the bumps on the road.
Why people lose money?
They fail to research the Companies, buying a Stock is not buying a lotto ticket, when you buy a stock you are actually buying a piece of a company, which means, you would never buy a company that have terrible financials, that is losing customers, asking for loans to cover their previous debts, or pretending to be the next amazon when they don’t even have an office. Guess what, that’s exactly what the majority of amateur investors do! They believe stocks are lotto tickets, and believe in fairies and miracles, and what happens later is not a surprise, the company goes bankrupt and people lose their investment.
I know that by know you have a good understanding of how the stock market works, why people invest in stocks and how they make money. What is even better is that you as an investor can buy and sell as many shares as you want. Only want to buy 1 share? You can! Can you sell your investments tomorrow and cash in? Yes you can! Can you do this online by yourself, from home using your computer or phone while wearing PJs? Yes you can!
Since you are understanding how this whole stock market thing works, why don’t you continue learning and check how you can turn $100 into $500,000 by investing in dividend stocks