There are a few ways to make money on the stock market. Each method has its pros and cons. Also, the amount of money you make will be depend on the effort you put in.
How do investors make money on the stock market?
An investor is someone who buys stocks with the intention of holding on to them for a long time. Investors make money from the stock market in two ways.
1) Capital growth
2) Dividends
Over time, the value of stocks tends to go up. The FTSE 100, for example, returned an average of 7.75% per year since its inception. American investors, meanwhile, have enjoyed even better returns; their stocks have risen 10% per year on average since the 1920s.
When the time comes to sell the stocks (perhaps many years later), a profit will be made assuming the price of the shares have risen in that time. This profit is known as capital growth.
In the interim, the investor may receive dividends. Normally, a company will pay X amount of pennies per share. For example. In the third quarter of 2020, British Petroleum paid £0.039 per share. This may seem like a tiny amount – and it is, but investors tend to hold thousands of shares so all those pennies per shares adds up. Investors that focus on earning from dividends are known as ‘income investors’.
Alternatively, the dividend yield, expressed as a percentage, may be used. This is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price.
Depending on the company dividend policy, shareholders may be paid dividends quarterly, every six months or once a year. There is always a risk, however, that the company may cancel a dividend pay-out altogether. This was commonplace during the Covid19 pandemic.
There are some companies that tend to avoid dividend pay-outs altogether. Amazon, for example, famously uses surplus cash to re-invest in the business. The result of this is that Amazon continues to increase in value and is now amongst the most valuable companies in the world.
If you want to be an ‘income investor’ you should obtain a list of companies that pay a high dividend yield to get an idea of which companies have a history of paying a good dividend.
Larger, more established companies with more predictable profits are often the best dividend payers. These companies tend to issue regular dividends because they seek to maximize shareholder wealth in ways aside from normal growth. Companies in the following industry sectors are observed to be maintaining a regular record of dividend payments:
Basic materials
Oil and gas
Banks and financial
Healthcare and pharmaceuticals
Utilities
The table below, obtained from the ‘This Is Money’ website, shows 20 big dividend payers from the FTSE 100. From a Muslim investor’s point of view, six out of the 20 can be ruled out straight away because their main business offering is haram (British American Tobacco, Diageo, HSBC, Imperial Brands, Legal & General and Aviva). In addition, Tesco sells both halal and haram products, so should be avoided as well. That leaves 13 that are potentially halal. I use the word ‘potentially’ because the remaining 13 have to go through additional shariah screening criteria. This means from the shortened list of 13, the final figure will be even smaller.
It’s interesting to note the final column showing which companies have cut their dividends in recent years. This is a very real possibility, so using past data can be helpful. Aviva and Anglo American, for example, seem to have no problem cutting the dividend, whereas others seem to pay no matter the economic landscape. What about 2021? No one knows for sure how much dividend a company will ultimately pay, but according to the same website, this might give you some idea:
In terms of percentage yield, the top two companies on the 2021 list above are expected to pay a very respectable yield of 9.5% and 9.3% respectively. Imperial Brands, however, can be eliminated straight away, and M & G needs to be screened for shariah compliance.
If two companies pay a similar dividend, it might be prudent to buy shares in the company that has a lower share price. In the event the investment doesn’t pan out as expected, it’ll mean the losses will be smaller.
How do traders make money on the stock market?
If you’ve read the article on the difference between a trader and an investor, you’ll know that there are several types of traders. Some of the main things to note about trading are:
Traders rely solely on capital gains (the price of stocks rising) – there’s no dividend income
There are two main ways to make money: (a) ‘buy on the dip’ (b) ‘ride the wave’
Trades (buying and selling shares) need to happen quickly because if it isn’t, the opportunity could be lost
The same initial investment amount can be recycled over and over again to maximise returns
‘Buying on the dip’
The ‘dip’ in the name refers to a dip in a graph. This strategy relies on finding stocks whose share prices have suddenly dropped. There are shares whose prices dip all the time, and finding these shares is not difficult. In fact, great care has to be taken not to buy a ‘falling knife’ (a stock whose price will not recover). What is more difficult is finding a stock whose price has dipped, but will pick up again in a short time frame, possibly within the same trading session.
There can be a number of reasons for why a company’s share price may suddenly dip, but broadly speaking, they usually fall into ‘micro’ or ‘macro’ reasons (or factors). Micro-reasons are things that are localised to a certain company (for example, a change of management). Macro-reasons are things beyond a single company’s influence. It could include things like a recession, a pandemic, a war or a whole host of things. Macro-reasons cause the share prices of whole industries to decline. For example, the coronavirus pandemic of 2020-21 battered the airline industry. It didn’t discriminate against strong operators like Ryanair and weak operators such as Norwegian Air Shuttle. The whole industry took a battering, with many requiring multi-billion dollar state bailouts.
In my experience, micro-factors move a company’s share price far quicker than macro factors. For example, if it is reported that the management of a company has engaged in fraud, it will collapse a company’s share price almost instantly. Assuming the company is otherwise robust, then a new management will result in the share price to rising again. In such a scenario, traders can make a lot of money.
Luckin Coffee, the Chinese answer to Starbucks, is a great example of micro-factors causing the share price to collapse. Luckin Coffee’s shares were trading at around $27 dollars before the company was found to be engaged in fraud. It didn’t take long for the share price to collapse to around $5.35 and then later to $1.35. I considered buying when the share price initially collapsed, but ultimately decided not to buy shares because I was not sure if it would survive the scandal. My preliminary research taught me that Luckin Coffee sells most of its coffee at heavily discounted prices via vouchers. So the inflated earnings were nowhere near the reality. On top of that, I wasn’t sure if Luckin Coffee would face any costly legal proceedings for the fraud. At the time, I was pursuing other interests, so although I missed out on this opportunity, I have no regrets. In hindsight, that was a decent judgement call because Luckin Coffee had to pay the SEC $180 million in fines. At the time of writing this article, Luckin Coffee’s share price had recovered a little to around $8.50, but that’s a long way from the $27 it was trading at before and an even longer way from its all-time peak of a $50 a share. Still, if a trader purchased at $1.35, and sold today at $8.50 then that's a fantastic return of 629%. The difficulty here is that when the share price hit $5.35, many thought that was the 'bottom'. Of course, hindsight teaches us that it wasn't ($1.35 was the bottom). But even if a trader purchased at $5.35 mistakenly thinking it was the bottom and sold today, that's still a profit of 63%.
One company I did get involved in was Boohoo, which was caught in a media storm over its operations in the UK. A newspaper ran a story claiming workers were underpaid and factory conditions were poor. The share prices eventually tanked a whopping 40%. The company was otherwise doing well, and given that the factories in question were not even owned by Boohoo at all, I knew the share price would recover. I ploughed in a small fortune to buy shares as low as £2.64. I use a technique I call 'batching' (which you can learn about in my 30 Day Trading Programme), which means I don't put all my eggs into one basket.
I later sold these shares at different price points...
and at different time points...
Traders like volatility in the market. This is because in a volatile market there are massive swings in the price of stocks. This allows skilful traders to identify and buy when the price dips, and then sell that same stock later on for a profit. If this can be done within the same trading session, then it means the original sum of investment can be recycled over and over again. With time, traders will find they get quicker at identifying those stocks, conducting a shariah screener on those stocks and making a decision on whether to buy the stock or not.
Buying on the dip is my favoured strategy as it builds in many safety nets, which I discuss in another article.
‘Riding the wave’ (fomally known as momentum trading)
There are some traders that seek stocks that are on the rise. These traders spend a lot of time analysing live graphs and when they believe the trend line is going to shoot up, they buy shares. They continually look for clues, such as volume of trade, and make a decision on whether to buy. As the theory goes, a high volume of purchase results in share prices increasing. This is based on the principle of supply and demand – if there’s a high demand for something, the price will go up.
You may hear phrases like ‘the trend is your friend’ from this camp, but personally, I find it risky. I find that bad news can bring down share prices by a really big percentage, but good news doesn’t cause the share price to go up so much. Traders in this camp pay close attention to when a company announces results because this usually causes share price to rise or fall. There are two things to note:
1) Buying shares before the announcement
Buying shares before a company announces their quarterly result will result in the biggest profit. Share prices can rise 20% or so almost instantly. But there is a huge risk: if the company announces disappointing results, the share price drops sharply. In fact, there are times when a company announces profit, yet the share price goes down. Where this happens, it’s usually because investors were expecting higher profits, so it’s seen as a disappointing quarter.
This should only be done if you know a stock very well.
2) Buying shares after the announcement
This is less riskier. However, investors need to buy almost immediately after a company announces a positive quarter. Given that professional investors are glued to their screens waiting to act, you’d need to be lightening quick to benefit from the wave.
To ride the wave, it helps to have sophisticated software. Using basic apps like Freetrade will not work well because of glitches, buy orders not being executed and so on.
The problem I find with this strategy is that if things don’t go to plan after buying the stock, and if the stock price begins to go down instead of going up, it basically means the trade has been executed at the highest price. That’s not to say the share price won’t recover, but it may take a while to do so. This approach is very short term. A lot of people make money on using this strategy, but for me, it’s not a safe enough strategy.
So, if investing is for you, happy investing. If trading is your game, happy trading.
No prizes for guessing which camp I'm in...
If you'd like to get started on trading or invsting on the stock market but feel there's more to learn, my free 30 Day Trading Programme could be for you.
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