Millionaire Expat. Andrew Hallam
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profits.
Those reinvested profits make Fifty Shades even more profitable. As a result, the company doubles its profits to $200,000 the following year, and increases its dividend payout to shareholders.
This, of course, causes other potential investors to drool. They want to buy shares in this hot undergarment company. So now there are more people wanting to buy shares than there are people wanting to sell them. This creates a demand for the shares, causing the share price on the New York Stock Exchange to rise. The price of any asset, whether it's real estate, gold, oil, stock, or a bond, is entirely based on supply and demand. If there are more buyers than sellers, the price rises. If there are more sellers than buyers, the price falls.
Over time, Fifty Shades' share price fluctuates—sometimes climbing, sometimes falling, depending on investor sentiment. If news about the company arouses the public, demand for the shares increases. On other days, investors grow pessimistic, causing the share price to limp.
But your company continues to make more money over the years. And over the long term, when a company increases its profits, the stock price generally rises with it.
Shareholders are able to make money two different ways. They can realize a profit from dividends (cash payments given to shareholders usually four times each year), or they can wait until their stock price increases substantially on the stock market and choose to sell some or all of their shares.
Here's how an investor could hypothetically make 10 percent a year from owning shares in Fifty Shades:
Warren Buffett has his eye on your business, so he decides to invest $10,000 in the company's stock at $10 a share. After one year, if the share price rises to $10.50, this would amount to a 5 percent increase in the share price ($10.50 is 5 percent higher than the $10 that Mr. Buffett paid).
And if Mr. Buffett receives a $500 dividend, he earns an additional 5 percent because a $500 dividend is 5 percent of his initial $10,000 investment.
So if his shares gain 5 percent in value from the share price increase, and he makes an extra 5 percent from the dividend payment, then after one year Mr. Buffett would have earned 10 percent on his shares. Of course, only the 5 percent dividend payout would go into his pocket as a realized profit. The 5 percent “profit” from the price appreciation (as the stock rose in value) would be realized only if Mr. Buffett sold his Fifty Shades shares.
Warren Buffett, however, didn't become one of the world's richest men by trading shares that fluctuate in price. Studies have shown that, on average, people who trade stocks (buying and selling them) don't tend to make investment profits that are as high as those investors who do very little (if any) trading. What's more, to maximize profits, investors should reinvest dividends into new shares.
Doing so increases the number of shares you own. And the more shares you have, the greater the dividend income you'll receive. Joshua Kennon, a financial author at About.com (a division of the New York Times Company), calculated how valuable reinvested dividends are. He assumed an investor purchased $10,000 of Coca‐Cola stock in June 1962. If that person didn't reinvest the stock's dividends into additional Coca‐Cola shares, the initial $10,000 would have earned $136,270 in cash dividends by 2012 and the shares would be worth $503,103.
If the person had invested the cash dividends, however, the $10,000 would have grown to $1,750,000.6
Let's assume Mr. Buffett holds shares in Fifty Shades while reinvesting dividends. Some years, the share price rises. Other years, it falls. But the company keeps increasing its profits, so the share price increases over time. The annual dividends keep a smile on Buffett's face as he reinvests them in additional shares. His profits from the rising stock price coupled with dividends earn him an average return (let's assume) of 10 percent a year.
The Stock Market Stars as the Great Humiliator
Choosing a company to invest in isn't easy, even if you think you can predict its business earnings. Over the long term, stock price increases correlate directly with business earnings. But over a short period of time (and 10 years is considered a stock market blip), anything can happen. This is why the famous money manager Kenneth Fisher refers to the stock market as the Great Humiliator.7 Over a handful of years, a company's business profits can grow by 8 percent per year, while the stock price stagnates. Or business earnings could limp along at 4 percent per year, while the stock market pushes the share price along by 13 percent.
Such a disconnection never lasts. Ultimately, a company's stock price growth will mirror its business' profit growth. If a stock's price appreciation outpaces business earnings, the stock price will either flatline or fall until it realigns with business earnings.
If business profit growth exceeds the stock's appreciation, at some point the stock will dramatically rise, realigning share price growth with that of business profits.
Connections between stock and business profits correlate strongly over long time periods—15 years or more. But over shorter periods, markets are mad because people are crazy.
Those trying to buy individual stocks need to forecast two things: future business earnings and people's reactions to those business earnings. For example, if financial analysts and the general investment public felt that Google's business earnings would grow by 15 percent next year, and the company's earnings grew by 13 percent instead, many shareholders would sell. No, I'm not suggesting such a move would be rational. It wouldn't be. But people aren't rational. Such selling would drop Google's share price, despite the impressive 13 percent business growth rate.
Predicting the general direction of the stock market is just as difficult. Even with a solid eye on the economy, human sentiment moves stock prices in the short term, not government policies or economic data. The existence of more buyers than sellers increases demand, so stock prices rise. Having more sellers than buyers increases supply, so prices fall. That's it—nothing more, nothing less. The stock market isn't its own entity, moving up and down like some kind of mystical scepter. Instead, its movements are a short‐term manifestation of what people do. Are they buying or are they selling? We move stock prices: the aggregate activities of you, global institutional investors, and me. Our groupthink is so unpredictable that most economists can't determine the market's direction. To do so accurately, they would have to predict human behavior. And they can't.
For example, imagine if every US economist were rounded up on January 1, 2020, to listen to a creepy soothsayer in a cave. “The world will face a global pandemic in 2020,” utters the cloaked, eyeless figure, as spit flies from his mouth onto the cold wet walls. “The US economy will shrink by 3.5 percent.”
This happened in 2020 (except the soothsayer dude is fiction).8
But even if such a soothsayer really told economists this, they would never have predicted that the US stock market would soar 20.96 percent in 2020.
However, over the long term, there's always a direct correlation between business earnings and stock prices. Warren Buffett's former Columbia University professor, Benjamin Graham, referred to the stock market as a short‐term voting machine or popularity contest, but a long‐term weighing machine.9 Business earnings and stock price growth are two separate things. But in the long term, they tend to reflect the same result. For example, if a business grew its profits by 1,000 percent over a 30‐year period, the stock price, including dividends, would perform similarly.
It's the same for a stock market in general. If the average company within a stock market grows by 1,000 percent over 30 years (that's 8.32 percent annually), the stock market would reflect such growth.
Over the long term, stock markets predictably reflect