How Do You Make Money in Stocks?

David L. Johanson |

Many investors choose to include shares of stock in their portfolios because stocks historically offer higher potential returns than other traditional investments, such as bonds and cash.  The trade-off is stocks can be more volatile.

Shareholders can benefit by owning stocks in three different ways.  The appreciation in the stock price is only one of those.  Companies also return wealth to shareholders through dividends and stock buybacks.

1.  Stock Price

If you measure performance with benchmark indices, then stocks have delivered reasonably attractive returns over time.  For example, the Standard & Poor’s 500 Index (S&P 500), historically, has returned 9-10% per year on average since 1928.

It is important to recognize, however, an investor who held the same stocks as the index would have experienced a pretty bumpy ride.  The 1928 through 2014 period included eleven years when the S&P 500 was either up (1928, 1933, 1935, 1945, 1954, 1958, 1975, 1995) or down (1931, 1937, 2008) more than 35%.

One of the challenges of stock ownership is share values can fluctuate depending on the performance of the underlying company, the perceptions of investors, or other factors over which the company and its investors may have little influence.

2.  Dividends

Some companies choose to pay cash distributions, called dividends, to their shareholders.  These are often large and well-established companies that want to attract investors even though their growth prospects may not be as promising as those of smaller or mid-sized companies.

Once a dividend has been established, investors expect it to remain stable or rise.  When a dividend is cut, it may be a sign the company is in trouble.  Some experts believe companies that pay dividends are more efficient in their use of capital than companies that do not pay dividends.

Historically, dividends have played an important role in total return.  In fact, since 1926, reinvested dividends have contributed about 33% of the total return of the S&P 500 Index.  So, reinvesting dividends has the potential to improve a portfolio’s performance over time.

3.  Share Buybacks

U.S. companies have been on a stock buyback spree.  A stock or share buyback occurs when a company buys shares of its own stock in the marketplace.  Repurchased shares may be absorbed or held by the company.  A share buyback may:

  • Reduce the number of shares outstanding
  • Improve shareholder value
  • Increase a company’s return on assets and return on investment
  • Improve a company’s price-to-earnings ratio

If the end effect of a buyback is the number of shares of stock outstanding in the marketplace is smaller, then the ownership stake of each investor increases.  In these cases, the value of outstanding shares may increase as well.

 

Stocks have the potential to reward investors in a variety of ways.  These include stock price appreciation, dividends, and share buybacks.  We generally like stocks that have the free cash-flow flexibility to take advantage of all three of these benefits for investors.