The ultimate Q&A to Stock Returns 101

Investing tips 06: This post about stock returns is part of a series of investing advice that has been collated from my Quora responses. 

The ultimate Q&A to Stock Returns 101
“Superior investors make more money in good times than they give back in bad times.”  Howard Marks

A stock return is a gain you obtain over time, which may be represented in terms of an absolute gain or a percentage gain. A positive return represents a profit while a negative return marks a loss.

Returns are often annualized for comparison purposes, while a holding period return calculates the gain or loss during the entire period an investment was held.

When I look at stock returns, I consider the total returns. The total return you get from investing would be from:
  • The capital gain i.e. the difference between the selling price and the buying price.
  • Other payments by the company to the shareholders. This could be dividends, capital repayments, or even stock bonuses.

The main point of looking at your returns is to assess whether you have grown wealth. To do this:
  • First, look at the total amount you have invested - your cost of investment.
  • Secondly, look at the current value of your investments. This is equal to the number of shares you have multiplied by the current price per share.
  • If the current value is more than the cost of your investment, you have grown your wealth.

This post focuses on issues of stock returns covering:
  • How to make money from the stock market?
  • How much can you make from the stock market?
  • Compounding.
  • How to analyze the returns. 

It is part of a series meant for newbies. I focussed on answering the questions from the view of a bottom-up, stock-picking, long-term value investor.  

I am coming from the perspective that you are interested to learn how to invest based on fundamentals.  This requires you eventually to analyze and value companies. 

If you don't want to do this, but still want to invest based on fundamentals, there are many third-party advisers who can do this for you. A good example is  The Motley Fool. Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.

This blog is reader-supported. When you buy through links in the post, the blog will earn a small commission. The payment comes from the retailer and not from you. Learn more.



Questions

1. How do people make money on the stock market without selling their shares?

2. Is it a good strategy to sell stocks to take profit and then buy them back?

3. Does a dividend figure into a stock’s rate of return?

4. If I invest $75 every month to S&P 500 for 30 years, will there be any profit?

5. How much money do I need to invest to make a $40k year passive income? 

6. How much can you make off of stocks per year? 

7. How can one spend/enjoy his stock returns, if it is always advised to compound your returns?

8. If traders can generate good returns every month if they can compound their returns, why are there no big billionaire traders?

9. What metrics can I use to analyze my stock portfolio?

10.  Why are stock investors unable to beat the S&P in the long run?


1. How do people make money on the stock market without selling their shares?
There are 2 ways to make money from the stock market - capital gains and dividends.

You get capital gain when the price of the share increases over time. It doesn’t matter whether the increase is due to fundamentals or market-sentiments. 

If you sell the shares when the current price is more than your purchased price, then you crystalized the gain.  However, even if you don’t sell the share, and especially if the value of the share has gone up due to its fundamentals, you would have achieved capital gain.

Can you get some money from this capital gain even if you don’t sell them? If you are borrowing money and using your shares as collateral, technically when the value of the share goes up, you could borrow more.

And of course, you can get money from the dividends. You should not look down on dividends. About 1/3 of my CAGR is from dividends. And I am not even a dividend king investor ie those who invest in high dividend-paying stocks.

In places that allow short sales, you can lend the shares to those who want to do this for a fee. 

There are of course risks and operational with the first and third methods but it does not change the principle.



2. Is it a good strategy to sell stocks to take profit and then buy them back?
What you suggest will work if you can see the future. How do you know that the price will drop after you have sold?

If it was so simple, there would be tons of successful investors all over the world.

The usual thing is that if you sell to take profit, it must be because you think that there are other better investments. Once in a while, you might be lucky that other investments are what you have sold. But I guarantee you that you cannot be lucky all the time.

If you are a value investor, you would sell only when the price exceeds the intrinsic value. If you have a situation where while there are some profits, but the price is still below the intrinsic value, you should continue to hold.

As a value investor, I have bought back shares that I have sold earlier. But this is because:
  • At the time of the sale, the price exceeded the intrinsic value.
  • At the time when I bought it back, market sentiments had changed so much that the price has dropped below the intrinsic value.

Over the past 15 years, the number of times when I had such a sale and re-buy situation was less than the fingers on one hand.



3. Does a dividend figure into a stock’s rate of return?
A dividend is a derived item in the sense that you can choose dividend pay-out as one of the investment criteria for stock selection.

If you do this, then of course dividend will be a big contributor to the stock returns.

As part of my risk mitigation process, I look for stocks with a long history of 3% to 5% dividend yield. Because of this over the past 15 years, dividends have accounted for about 1/3 of my total stock returns.

In a sense dividend is a form of capital payment.  Technically, any profits retained become part of the capital of the company - any payment of a dividend is then a return of capital.

A stock that does not pay dividends does not mean that it is a non-productive asset.

There can be valid reasons for a company not to pay dividends eg they have new projects with good returns that require capital. In such a scenario, the value of the company will grow with time. You are not just dependent on someone offering you are higher price regardless of the business.

As the business becomes more valuable, its share price will eventually reflect this.
 

4. If I invest $75 every month to S&P 500 for 30 years, will there be any profit?
The answer depends on what you mean by profit.  To sum it up, the S&P 500 compounded annual returns are:
  • Over the past 10 years - 11.2 %.
  • Over the past 20 years - 4.0 %.
  • Over the past 30 years - 7.7 %

Based on 7.7 % compounded annually, $900 ($75 x 12 months) invested 30 years ago would be worth $8,200. But of course, you would also be investing $ 900 every year.

If you work out the maths, your $ 900 X 30 years = $ 27,000 invested over the 30 years period based on a 7.7 % return every year would be worth about $ 103,000.

If $ 103,000 minus $ 27,000 is your idea of profit, then, of course, it is profitable.

Unfortunately, life is not so easy. Over the past 20 years period, the S&P500 only generated about 4.0 % compounded annually. Based on this 4 % over a 30 years period, your $ 27,000 would only be worth about $ 52,000. So, it is less profit compared to the earlier example.

But if you are lucky, over the past 10 years, the S&P500 generated an 11.2 % compounded annual return.  At this rate, your $ 27,000 would be worth about $ 207,000. You made more profits.

I am not sure whether you are in the US, but the S&P500 indirectly reflects the US economy. So how much you get over the next 30 years will depend on how the US economy grows.

But I am sure that the economic growth (and the S&P 500 growth) will be better than whatever returns you can get from saving deposits.



5. How much money do I need to invest to make a $40k year passive income? 
The answer will depend on the returns you achieve. If you can get a 10 % return annually then you just need $400k.

The challenge is whether you can get 10% annually. The S&P 500 index had a compounded 10% for the past 10 years so in theory if you had invested into an index fund based on this you would meet this target.

Unfortunately, this is not 10% every year. If you want a steady 10% then you probably need $ 1 million that is invested partly in the stock market and partly in some bond-like instrument.

Warren Buffett in his partnership days achieved about 15% compounded annual return. If you can get this return then you only need $ 267k. 

For the layman, you should forget about trying to get 15 % every year. Those who have done this are either entrepreneurs whose business took off or really savvy investors like Warren Buffet. For the rest of us mortals, we should settle for maybe double to triple the bank savings rate as something achievable.

If you are very, very lucky to be able to achieve a CAGR of more than 15%, then it may better to consider other investments eg:
  • Buy a lottery.
  • Invest all in one stock.
  • Invest all in a business so that you can sell out in 5 years’ time.
  • Put it as a down payment for a house.

For the majority of us mortals, the likelihood is to get maybe 2 to 3 % better returns than the stock market index. Accordingly, if the stock market index can achieve 10% compounded annually, you would have a fantastic performance.


6. How much can you make off of stocks per year? 
What you can make will depend on your time frame, the market you trade, and your investment style.

I think that the base return must always be the stock index of the market you invest in. If you don’t perform better than this, you might as well be an indexer.

The table below shows the returns from various markets taken from my post "Baby steps into the investment universe part 1″.

Index returns for various stock exchanges
As you can see different markets have different returns for different time frames.

So, if you are investing in the Bombay stock market and you don’t make 12 to 13 % annually over a 10 to 20 years period, you should hide your head in shame.

On the other hand, if you are investing in the Toronto market and you make a compounded annual return of 5%, you should be proud.

The point is that you will never know how your market will perform in the future so it makes more sense to set a target that is + 2 to 3 % more than the relevant index return.

It is obvious that a good return should depend on where you are and has to be looked at in the context that investing at its core is about protecting your savings from inflation.

If you have this view, I would think that your benchmark should be doubled the inflation rate in your country.

In his partnership days, Warren Buffett average about 15% compounded annual returns. This means that he will double his investment every 5 to 6 years.

As you can see from the table the return for Nasdaq over 10 years was 15 %. I would say that you should realistically aim for doubling every 10 years.



7. How can one spend/enjoy his stock returns, if it is always advised to compound your returns?
You grow wealth thru the power of compounding. This means having consistent high returns over decades of investing.

If you start young and are still working, you may have the ability to add new funds to your investment every year in addition to reinvesting the annual gains.

Warren Buffet in his partnership days achieved a CAGR of 15%

Based on a 15% CAGR, if you start at 30 with $ 10k and add $ 10k every year, by the time you are 65, you will have $ 10.1 million.

If you can only save $10k every year, I deduced that your annual expenditure is $90k.  By the time you are 65, your investment is such that you can spend $90k and yet have excess gain every year to reinvest.

My point is that if you are able to achieve a high CAGR, you will reach a stage where you can enjoy your returns and yet have monies left over to reinvest.

The challenge is achieving a high CAGR.

In the example above if the CAGR is 10% instead of 25%, what you have by 65 is not $ 10 million but $ 3 million.



8. If traders can generate good returns every month if they can compound their returns, why are there no big billionaire traders?
If you want to compound your investments, you will have to reinvest part of your profits.

If you take out all our profits, your invested capital will remain the same. Sure, you will get “income” from the profits taken out. But you will miss the most powerful thing about investing - the compounding effect of reinvesting your gains.

The power of compounding means that if you can get consistent returns every month and you repeat it over decades you will become very rich.

So, if there are no big billionaire traders, it could mean:
  • They don't get consistent results like you imagine.
  • They stop trading after a while - doesn't seem likely.
  • There is no such thing as the power of compounding.

Which do you think is most likely?


9. What metrics can I use to analyze my stock portfolio?
Your metrics should inform you about how well you are doing with regard to the objective of the portfolio.

The first is of course the returns. Measure its current value c/w your original investment. This will give you a sense of your return which you can compare with maybe the bank saving rate or the stock market index return.

There are several ways to measure the return:
  • You can look at the absolute return. You figure out how much money you made.
  • You can look at % return. You look at the amount you have made in comparison with the amount you invested. 
  • You can look at the return from a risk-adjusted basis. For example, many use the Sharpe ratio or Information ratio for this.

Apart from returns, you should also assess whether the non-financial goals of the portfolio have deviated over the review period. 

If you created the portfolio to be diversified, then you should assess how diversified you still are using the various diversification factors. For example, 
  • If you are trying to be invested in different sectors, then measure the amount invested in each sector (do it by $ as well as % of total investment). 
  • If you are trying to be equally spread by market cap, then do the same analysis by market cap. Compare the actual against your original target

I know that there are lots of other academic ratios available, but if you are a layman just investing to grow your wealth, I don’t think there is any value in adopting all those measures.

At the end of the day, you just want to know:

a) How well you are doing relative to your default investment.

b) Whether your diversification plan has been achieved.



10.  Why are stock investors unable to beat the S&P in the long run?
Mathematically if the S&P represents the average performance, this means that there will be some who do better to offset those that do worse.

The question is whether there is consistency ie whether those who do better in one year will continue to do so in the subsequent years.

Well, the value investors like to point to Warren Buffett as an outlier who has done this. There are others as well.

So why are some investors unable to beat the index? The stock market is a zero-sum game.  Every time you buy thinking that the price will go up, there is someone else on the other side selling thinking that the price will come down. Only one of you can be right.  Usually, it is the experts who are right.

So, in order to do well, you need to develop investing skills. I am sure that there are many retail investors who do not bother to do this.

Secondly, it takes more than merely having the knowledge of what to do. There is a strong behavioral element in investing. Different investing styles require different behaviors. For example, if you are a value investor, you need to be patient and probably not listen to the daily stock news.  Many investors do not have the temperament for investing. 

Given these challenges, are you surprised that many stock investors are unable to beat the index?


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