The single most life changing lesson I ever learned about investing in stocks and the stock market came when I was a teenager. I was reading the 1973 edition (4th edition) of The Intelligent Investor by Benjamin Graham in the white rocking chairs at La Guardia Airport, waiting to take a flight home to Kansas City from college to visit my family during Thanksgiving.
Today, the same copy sits highlighted in my office, with notes scribbled around Chapter 8, in which Graham states, "Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment."
Investing in Stocks Is Like Owning Private Businesses Because the Drivers of Success Are the Same
Although it was a long time ago, it was in that moment that I "got it". If I owned 25% of a local ice cream parlor, my plan would not be to make money by buying or selling ownership from the other equity holders, taking advantage of their ignorance, greed, or fear. Instead, my strategy would be sustainable. I would want to make money by generating cash from ice cream sales, opening new locations, and plowing profits back into the enterprise for expansion. If we couldn't earn a good return, the cash would be distributed in the form of dividends so I could find something else to do with the money. The stock market is no different. An individual share of stock is no different than a limited partnership unit or a limited liability company membership unit.
My job was to take the cash I earned in my day-to-day life and use it to buy ownership of proverbial ice cream parlors. I wanted great businesses that earned high returns on capital, had little to no debt, pricing power to protect against inflation, and strong franchises to act as insurance against the inevitable subpar management, which will come along from time to time. I would routinely write checks and deposit them in my brokerage account, buying ownership in everything from industrial sealant manufacturers to teen apparel companies, regional property and casualty insurance underwriters to auto part stores. The dividends would come in, get added to the new cash I deposited, and used to buy more ownership in firms that appeared attractively valued.
There were some fantastic capital gains along the way, but I hardly ever sold anything. The general philosophy was, if I needed to sell, I made a mistake in the beginning. Great businesses rarely change. It can happen - just look at what became of Kmart and Sears in a world of Wal-Mart and Target - but it often occurs over long periods of time, right in front of you. I loved the idea that, someday, the annual dividends of some of my investment positions would exceed the cost basis of the original shares.
I saved, and acquired, watching my net worth grow. Even the Great Recession collapse, which caused equity prices to fall 53.9% from peak to trough from October 9, 2007 to March 9, 2009, was nothing more than an opportunity to buy more of the companies I loved and expand the wholly owned private businesses I controlled. As a result, my net worth and income are far higher than they were five years ago.
Inexperienced Investors Continue to Sell Off the Very Assets That Can Make Them Rich
Yet, constantly, I hear from readers, and even my own family members, who, at the first sign of trouble, sell off the very assets that throw off cash and passive income for them. It's like a farmer going out and ripping up the seed he planted only a few weeks prior. You cannot get rich doing that. Then, these same people, at the first sign of prosperity, use their cash to buy assets that lose value. They will borrow money to purchase a $30,000 Ford, adding $7,000 in interest costs on top of it, but never once consider buying a $7,000 car, instead, paying cash, and using the $30,000 to buy shares of a high yielding blue chip stock like Royal Dutch Shell, which would throw off more than $1,410 in cash the first year. Who cares what the stock price does from month-to-month or even year-to-year? You now have an extra $352.50 mailed to you in cash every three months, with a very good chance of that figure getting higher in the long-run.
You don't have to do that many times in life to make a difference. Think about what we discussed this morning when we looked at how a $100,000 investment in Wal-Mart Stores a decade ago, with dividends reinvested, now pumps out cash dividend checks of $12,696.92 per year, or $3,174.23 every three months. If Wal-Mart repeats that performance, and our theoretical investor continues to hold for another decade plowing dividends back into the DRIP or direct stock purchase plan, the math indicates that he or she will be collecting $51,258+ in cash dividends per year, or $12,815 every three months. A single decision made twenty years prior would have enormous, lasting consequences for the better. I don't care how rich you are, $51,258 in extra cash coming in automatically every year is real money, even if you want to give it all to charity.
The Checklist For Getting Rich
If you want to retire rich, there are five things you need to do:
- Bring in more money than you spend, leaving a surplus. There are only two levers you can pull to achieve this.
- Place this surplus in some sort of tax-advantaged entity, account, plan, or organization
- Put that surplus to work for you as you would an employee, avoiding unnecessary risk and earning a return that exceeds taxes and inflation by a comfortable margin.
- Add to these funds year after year by depositing new surplus capital and reinvesting the cash generated by your holdings
- Wash, rinse, and repeat for several decades
There is no magic to the process other than the miracle of geometric compounding. It is so powerful that over a 50 year period, you could have 9 out of 10 starting investments get wiped out along the way and still retire much richer than you would have otherwise been. Very few investors enjoy these returns, though, because they are constantly buying and selling, trying to make money by being clever and taking advantage of the foolishness of others, rather than collecting their share of the underlying earnings in the businesses they own.