There are no guarantees to making money when it comes to the stock market. But long-term investors that own diversified portfolios of stocks will almost always earn money if their time frames are long enough. Two mechanisms are available to earn money in the stock market: cash dividends and capital gains.
Cash dividends are payments made by companies to shareholders. You can seek out companies that have high dividend payout rates, that consistently pay dividends and whose dividends consistently increase. There are two metrics for analyzing a company's dividends: the dividend payout ratio and the dividend yield.
Calculate dividend payout, expressed as a percentage, by dividing a company's annual dividends by its annual net income. Dividend payout equals the portion of a company's earnings paid out to shareholders. For example, if a company makes quarterly distributions to shareholders of $1,000 and records annual net income of $10,000, its dividend payout ratio equals 40 percent (four payments totaling $4,000 divided by net income of $10,000.)
Dividend yield is equal to the company's dividends to shareholders divided by its market value and often is on a per-share basis. For example, if a company pays total annual dividends of $2 per share,and records earnings per share of $10, its dividend yield equals 20 percent ($2 divided by $10).
You can invest in industries that typically have high dividend payout and yield ratios, such as banking and utilities, or use online screening tools to find companies with high dividend payment rates. Investors prize high dividends, because they represent regular, high cash returns. Companies that consistently make dividend payments provide highly predictable short-term returns, while capital gains are less predictable, except over the longer-term. Also, high dividend payout and dividend yield ratios are easy to analyze.
Be cautious in chasing high dividend yields, however. A company that pays higher dividends may return lower capital gains in the future. The high dividend payout may be a sign that the company has few opportunities for capital investment.
Capital gains occur when a company's stock increases in value. They don't reflect cash returns until you sell the stock, however, realizing those gains. Before sale, they are unrealized gains (or losses). Detailed data on stock market returns going back to 1926 demonstrates that investors who hold diversified portfolios, such as market indexes, earn long term, on average, 5.5 percent above long-term Treasury bond returns. Long-term investments generally are those held for seven or more years.
The amount by which stock returns exceed bond returns is the market risk premium. Therefore, if the 20-year Treasury bond is currently yielding 3 percent, the market risk premium indicates that you can expect a return on common stocks of approximately 8.5 percent (3 percent plus 5.5 percent). In some years, your diversified investment portfolio may earn negative returns, and in other years returns will be much higher than 8.5 percent. But in the long term, an investment in the market should yield returns of approximately 8.5 percent.
You can invest in the market by opening a brokerage account and investing in exchange-traded funds that mimic the performance of the broader market. No individual can beat the market over consecutive years in the long-term. It is more important simply to have an investment in the market, which ETFs make very easy. You can be purchase them through your brokerage account just like individual stocks.
Minimize transaction costs to maximize returns by investing in low-cost investment vehicles such as exchange-traded funds. Avoid selling holdings after steep price declines. Begin by assessing your investment time horizon and risk tolerance level and invest accordingly.