The Bacteria story
Let’s say you have a bacteria in a container; this container can host at most 1,000 bacteria; every minute the bacteria duplicates so at minute 0 you have 1, at minute 1 you have 2, at minute 3 you have 4 and this process continue indefinitely until the container Is full; how long would it take to fill up all the container?
I will save you the math involved and will give you the answer, it takes about 10 minutes the get the container full; now, what happens if you provide another container the same size for the bacteria to continue growing? How long would it take for that other container to be full? If you guess 10 minutes you are… wrong ☹. It actually takes 1 minute. But why? Well, each of all those 1,000 bacteria would duplicate forming an additional 1,000 bacteria in 1 minute. This my friends is called compounding. And this concept will make you rich.
Compounding is the way that a lot of things in this world behave, from the stock market to the population growth the power of compounding will make you a millionaire and will collapse the sustainability of this world in the near future. Let’s focus on the first one, but I will let you understand my second statement by watching this Youtube video.
If you allocate $100 in an investment vehicle that gives you a 5% return per year at the end of the first year you would end up with $105; the second year you would have $110.25, the reason why you got 25 cents more than the previous year is because your balance at the beginning of the second year was $100 plus the $5 you earned so both of these numbers are increased by 5%. 25 cents don’t seem like much but after around 14 years you would duplicate your original investment.
So what happens if there is no compounding effect? like if you pull out the interest you gain every time it is paid? Well, the calculation is simple; you make $5 per year so you would duplicate the money in 20 years. Do you get it? the compounding effect saves you six years to duplicate your investment.
Let’s assume that it is 2012 and you want to buy some expensive sneakers, to have round numbers you would pay $1,050 for the special edition Nike air. Instead, you read this blog and decided to go to Walmart and buy the copycat for $50 and with the rest of the money you buy Nike stock, the price of the stock on September 2012 was about $20 and it paid about 1% dividend yield (I will expand in these terms in a bit); At $20 per share you bought 50 shares.
Nike stock today is worth $105.66 and since you had 50 shares the amount of money would be $5,283.00, but wait! You had an additional 1% dividend yield bringing that amount to $5,552.5 Let that sink in! a small sacrifice made your money grow five times as much. You now can afford five pairs of Nikies or what I prefer 111 Walmart sneakers. You see, a small sacrifice might have given you all the sneakers you will need in your lifetime.
So how exactly does this work?
I attached this calculator; just type your initial investment, the percent increase per year, the dividend yield and how many years out you want to predict.
In case you were wondering, the US stock market has returned 8% per year on average (without dividends) try setting 8% increase and 1% dividend and see in how long it would take to duplicate your money.
So this is how things work: companies need money to operate, if they generate money and with the profits they finance their operations then it is really hard to grow the company as the only money available is whatever is left after paying all the employees, raw materials, utilities, rents, loyalties, etc. Some companies prefer to operate this way, they are often referred as privately held companies and they finance growth through bank loans; the average person cannot invest in these companies unless they have some connection to the owners; examples of privately held companies are Hershey or the owners of Trader Joes and Aldis.
The other type of companies are those who participate in the stock market; instead of borrowing money from the bank to grow their business they offer small chunks of the company to people or other companies interested on financing the growth of the company; these are called stocks and for know just consider that when you buy a stock you are buying a certificate establishing a small percentage ownership of a company.
So what happens with your money when you buy a stock? you basically purchase the stock, the money goes to the company and the company uses the money to grow the business, they buy machinery, they hire people, they develop projects, etc. As the company grows and generates more money the stock increases in price because the company is worth more and there is more demand for the stock. So you actually make money as time goes buy.
Companies may choose to give some money every quarter (or year) to stockholders as an incentive for the investor to continue buying the stock and not to sell the stock for the people who owns it; the company offers certain percentage of money per share owned. When the dividend is paid the stock value decreases by the amount of the dividend, so the money you get comes at a cost.
I generally prefer owning non dividend paying stocks; the reason is that I want the company to use 100% of my money in growing their business, remember that 100% of my money will compound and if I get a dividend then just a portion of that 100% would compound. There are different ways and opinion about dividends and it does stir controversy among investors. I focus my investment strategies in aggressive growth and I am anti-dividend but there are several people who prefer the money every quarter.
Perhaps you would think about getting the dividend and buying more shares of the company immediately, the problem with this idea is that when the companies pay the dividend you get income which is taxed. Dividends are mostly a bad idea, a better option is to buy stocks in companies known not to pay dividends but that buy their own stock when they have extra cash to reward the investors (hence increasing the price of the stock).
Deciding what stock to buy
Buying stocks is just hard, in general I don’t recommend to beginner investors to buy individual stocks because a lot of things can go wrong; for example, you might think that a company like Macies would be a good bet because it offers a juicy dividend and it has been in the market for a long time but that is not the case, retail is slowly dying in the US and most retail companies will go bankrupt. If the company goes bankrupt you just loose all your money.
My advise for now is to avoid individual stocks unless you really know what you are doing; Do not buy based on trends or news. Buying individual stocks require an analysis of hours and even days that beginner investors don’t know how to do.
If you really want to buy individual stocks follow the following rules:
- Invest only the money you wont need in at least one or two years, it can take a long time for a stock to deliver significant returns and it may go under for a long time.
- Do yourself a favor and never buy IPOs (initial price offering – when companies go public for the first time); buying IPOs is not better than gambling and I strongly believe is a gamble which odds are against you.
- Look at the company’s balance sheet, if there is too much debt you must understand why and how the company is going to pay for the debt. A growing number of clients or users is an indication that the company might be profitable in the future (but not a guarantee, like UBER or LYFT, I don’t think they will become profitable anytime soon if ever).
- Do not buy stocks in dying industries, you will loose your money sooner or later (Retail stocks, shopping center REITS, others)
- Right now technology is king, if you don’t see any kind of technology in the stock you are buying be very careful or don’t expect much from it.
- If you are buying a company whose stock is stable and you don’t expect a significant return you are much better off buying an ETF (Exchange Traded Fund)
How to invest in stocks
Investing in stocks is easier than ever, you can just contact the customer service department of a brokerage firm and they will guide you through the process, you will need a minimum investment of about $500.00 but with that amount of money don’t expect much. As you grow your investments the amount will slowly complement and eventually replace your salary. In my case I was able to fully replace my salary in 10 years, I attest that is doable and not hard. It just takes time and effort.
Some brokerage firms are Vanguard, Fidelity, JP Morgan Chase, Robinhood. All of these offer 0% commission in trades and no fees. You need to find a broker with no commissions or fees because you will be investing at least once a month when you get your salary.