Hey I'm Fool.com editor Nick Sciple, and on this episode of FAQ we're answering the question you've all been asking: How DO you make money in the stock market?
People invest to make money: plain and simple. Except in special circumstances, like shorting a stock, investors buy a stock with the hopes that it will increase in value, allowing him or her to sell the shares later at a higher price and pocket the difference as profit.
But how can we know that a stock is going to go up -- before we buy it? In the short term, stocks go up or down for an endless number of reasons, from military conflict and news releases all the way down to individual Tweets. However, there's only one reason a stock prices increase or decrease over the long term [which is all that matters]: to match the value of a company's assets and cash flows. As Ben Graham famously said, "In the short run, the market is a voting machine, vacillating based on the news of the day, but in the long run, it is a weighing machine, measuring the actual value of a business."
Now that we know why a stock's value increases over the long term, we can answer how to make money in the stock market. There are 2 ways make money in the stock market: buy a company for less than it's worth OR buy a company at a fair value and hold it as it grows over time.
Imagine I offered to trade you a $1000 car for 500 bucks. Would you take it? Most of you probably said yes -- Free 500 bucks, right? You know you can take that car, and with patience and effort, find a buyer for the car's full value. Maybe the seller didn't want to put in that effort, didn't know what the car was really worth, or for whatever reason, needed the car gone quick. and that's why she sold it to you. This same thing often happens in the stock market: a stock falls out of favor, whether due to bad news around the company, market volatility, or innumerable other reasons, and its price falls below what the company would be worth to a reasonable purchaser based on its earnings and assets. Intelligent investors can then purchase shares of the company for less than the company itself is worth, and just like with the car, sell the shares for a tidy profit once the market realizes its mistake. Also like the car, it may take a long time to find a buyer, markets can remain irrational for a long period of time.
However, this strategy has been among the most successful in the history of investing. This approach, buying shares of companies for less than the resale value of the company as a whole, is known as value investing, and has been used for decades by famous investors as Warren Buffett and Benjamin Graham to build incredible wealth.
Now, imagine I offered to sell you a grocery store in a small town of 100 people for fair value. This grocery store is the only one in town, everyone in town shops there for all their food, and it’s profitable. You know that in 5 years a new factory will be built in the town bringing 500 new people to the area and the total population up to 600 people. Would you take my offer?
Of course you would! You know that in 5 years the grocery store will have 6 times as many customers as it has today. With a larger customer base, it should pull in even more money, making the store look extremely undervalued in 5 years!
This same phenomenon often occurs in the stock market. For example, when Amazon went public in 1997, it enjoyed a market value of around $450 million. Over the ensuing 20 years as consumer preferences have shifted toward e-commerce and the company has wrangled emerging trends like cloud computing, streaming games, and advertising, Amazon's earnings have skyrocketed by 34,000% as it has enjoyed growth in those markets and the company now holds a market value of ¾ of a trillion dollars. For investors who were patient -- and confident-- enough to hold the company for the long term, through 50%+ selloffs, competitive risks, and probably some boredom, Amazon has provided life-changing returns.
This investing style, buying companies with promise for future growth and holding for the long term to realize benefits from growth, is known as growth investing and has been used by investors like Phillip Fisher and The Motley Fool's Gardner Brothers to great success.
Whether you invest for value or growth -- or you shoot for some of both -- successful investing requires knowledge and patience:
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