Last Updated on February 4, 2021 by Oddmund Groette
Is it possible to get rich from stocks? If so, how can you do it?
It’s possible, of course, to get rich from stocks, given certain assumptions. This article gives you some advice on how to go about if you want to make a decent nest egg from investing. How much you accumulate is dependant on capital (how much you save and invest), the return, and the time spent in the markets. You need to understand how to compound your money most efficiently.
Three variables are needed to get rich
Three variables determine your wealth: capital, return, and time. The capital is the amount you invest, either from savings or reinvesting the returns (dividends, for example). The return is, obviously, the return from the capital you invest. The third variable is the time you spend in the market. All three variables are important, but as you will discover in this article, they all influence the result differently. You need to understand all three variables and how they interact.
What is “being rich”? What is wealth?
Wealth is relative. Many live their dreams by having minimal monetary assets. They might consider wealth in the intangibles: free time, clean air, free from stress, free from violence, etc.
Unfortunately, many compare their wealth to other people: keeping up with the Joneses. We use our surroundings as a measurement for how successful we are. However, when you use your neighbors as a benchmark for success, you will never appreciate what you have and will stay feeling miserable. Someone having 100 million USD in assets might feel poor if they live among wealthier people.
Thus, wealth is, and always will be, a relative issue. In this article, we consider “rich” as having enough to quit your job and live off your investments, although we don’t recommend to stop working. We believe having a job is very important, whether you need the pay or not.
How much do you need to make 3 000 USD a month?
If you need 3 000 USD a month, you need a pretty big investment portfolio. To pay your bills, you can have dividend “income” or sell shares/units to pay your bills – or both. The current dividend yield on the S&P 500 is about 1.75%; thus, you need about 2 million dollars. This amount might scare off many people, but you can play with numbers to see how much you need to invest and wait before reaching this amount.
Even though the dividend yield is 1.75%, the current earnings yield on the S&P 500 is 3.5%, meaning you can withdraw more without depleting your capital: then you need “only” one million USD.
However, the amounts are, of course, very uncertain. No one knows about the future, and you should always calculate with a wide margin of safety.
What are the odds of getting rich from stocks?
We would say it’s pretty good odds, of course, depending on what you consider rich. However, it takes time and patience. To start, you need to invest capital:
You need capital to get rich
The first variable to succeed is capital. If you have no capital to invest, you will, of course, not generate wealth. You can generate capital in many ways. You can work and earn more, or you can downsize and save more – or both.
When you have invested your capital, you need time to let it compound:
How long does it take to get rich from stocks?
The second variable is time. Time is how long your capital is going to work for you. The more time you have for your investments to grow, the more wealth you generate. You will not get rich in five years, and certainly not overnight. We are talking about decades. You need to compound your investments and reinvest the returns.
Because most people don’t understand compounding, they believe they need a home run to make it rich. But compounding is not about greatness – it’s about avoiding costly mistakes, staying power, and delayed gratification.
To illustrate the importance of time, let’s assume you invest 100 today at 10% return and let it compound for 30 years:
After 30 years, you have nearly 1 800. Not bad! As you can see, the longer you wait, the faster it grows.
But what happens if you wait another 20 years – in total 50 years?
By waiting an additional 20 years, your investment grows from 1 800 to 10 600—the wealth balloons. You managed to make an eighteen-bagger the first 30 years but made 88 times your investment by waiting for 20 more years. This is compounding!
Someone once said that good things take time and bad things happen instantly. It’s the same with investing. Stocks rise slowly over time, and once in a while, it drops instantly and fast. Bear markets are much shorter than bull markets.
Time is precious – start saving when you are young
Warren Buffett has become very wealthy because he is patient. 99% of his wealth came after he turned 50, and 97% after he turned 65. Buffett’s authorized biography is called Snowball. It’s no coincidence. Compounding is about snowballing: as you roll a small snowball in wet snow, it grows bigger for each turn. Compounding works the same. As the wealth grows, the returns get added to an ever-increasing base of capital. Of course, the result is dependent on an annual positive return:
Positive investment returns are required to strike it rich
The third variable is the investment return. The book Triumph of the Optimists calculated the stock market returned about 7-9% annually for most developed markets over the last 100 years. Most likely, this return sets the ballpark for what you can expect in returns over long periods, even though the returns vary a lot, even over periods of 20 years. There are no guaranteed investments. Historical returns can be a false “promise”!
Over time even small differences amount to significant amounts. If you get 8 or 10% matters a lot. Just look at this chart:
If you invest 100 at 8%, you accumulate 1 000 after 30 years. This compares to 1 800 if you manage 10% over the same period, 80% more!
Time trumps your savings rate
Perhaps contrary to what many believe, the time you spend in the market is more important than how much you save and invest, thanks to the snowballing/compounding effect. Let’s run two examples:
If you invest 10 000 annually for 30 years with a 10% return, you get this graph:
During the period, you managed to save 300 000, and your wealth grows to about 1.8 million.
But what happens if you don’t manage to save in the early years? Perhaps you have kids and are paying off the mortgage on the house. However, you force yourself to invest 10 000 in year one, but then nothing over the next ten years. After working for ten years, you have increased your salary, and you manage to invest 15 250 over the next 19 years, thus saving an equal amount as in the first scenario (300 000). But you are lucky, the market is in a roaring bull market, and you manage to get a 12% return in the last 20 years, not 10%. How do you fare compared to the example above?
The blue bars are the first example, and the red bars are the second example where you save most of the capital during the last 20 years. Unfortunately, the increased return can’t compensate for the lack of savings in the first ten years. More years are required to compensate for the saving-deficit or even bigger returns (which is unlikely).
The earlier you start saving and investing, the better. Even small monthly amounts could potentially add significantly to your pension.
Should you invest only in stocks? Or diversify?
History shows that stocks have been the best asset class over time. However, real estate is probably the most straightforward investment option for most people as it has a business model that everyone understands. Furthermore, many already indirectly save in real estate via their mortgage. You can get exposure to real estate either via direct investments or REITs.
Direct real estate investments might turn to be a better investment because most people take a long-term view on owning real estate, while the urge to buy and sell is much stronger for stocks. Why is that? One reason is that stocks are traded daily 6.5 hours per day with constantly moving prices. Opposite, real estate prices are measured once per month and the urge to “flip” is much less.
Should you diversify only among stocks/funds or other assets? We believe you should own both asset classes. The reality is that you are unlikely to be the next Warren Buffet, and thus it makes sense to diversify your holdings. Both asset classes have proven to generate wealth over long periods and should also protect from inflation.
For 90% of the investors, it makes more sense to buy ETFs and mutual funds than to buy single stocks. Very few stocks beat risk-free short-term Treasuries, and you avoid a lot of headaches by spreading your investments among a few funds, both managed passive and active.
Investing is about avoiding ruin
Nassim Nicholas Taleb writes that rationality is the avoidance of ruin. To be a successful investor, you need to avoid costly mistakes that don’t let you compound your capital. Why is that? If you lose your capital, you can’t compound—the sequence of returns matters. If you lose 50%, you need a 100% gain to recover. If you lose 25%, you only need 33% to recover. If you have a decent amount of money, you don’t want to waste that by taking unnecessary and potentially costly risks.
Unfortunately, the stock market doesn’t give an annual return like clockwork. Even though the return has proved to be 9% over a century, it’s unlikely that the return will be exactly 9% any year. We can measure in average return or annual compounded return. The latter is the correct one to use and is called CAGR – compound annual growth rate. It’s not an arithmetic mean, but the geometrical return from the beginning to the end (and is always different from the arithmetic average). If your annual return over five years is 10%, 15%, 17%, 19%, and -25%, your average return is 7.2%. However, the CAGR is lower at 5.7%. The reason is the terrible year in the end.
Sequence matters, something that Taleb calls path dependence in the book Antifragile. The more speculative portfolio you have, the more it will swing, and the more likely you are to experience huge moves on the downside, which can make it challenging to make a comeback.
Can anyone get rich by investing in stocks?
Yes, you don’t need to be intelligent or smart to get rich investing in stocks. Your most important asset is delayed gratification. However, that is a skill very few possess. To strike it rich requires enormous patience, not intelligence.
The simpler you make your investment plan, the better. Don’t aim to beat the market:
Don’t try to beat the market if you want to get rich
Aim for an average market return. Don’t try to be smart – the odds are against you – plan your investments as simple as possible and always include a margin of safety. Surveys show women are better investors than men, and this is no coincidence. They are not trying to outsmart the market, and most women save, invest and forget about it. The vast majority of private investors fail to beat the market, and you can regard it as a victory to manage the same return as the market. If you get the market’s return, you beat the majority of the professional industry!
Investing and inflation
Most reported returns are gross and not adjusted for inflation. Inflation means your purchasing power is reduced by 2-4% every year. The rate has been benign or falling since the 1980s, but that doesn’t mean it’s gone. Central banks are literally printing money, but this has yet to spill over to consumer goods. But we never know about the future. However, we believe that both real estate and stocks should provide the best hedge against inflation over many years.
Conclusion: How do you get rich from stocks?
The key variables are capital, investment returns, and time. Investing is no rocket science. Spread your investments among some ETFs and mutual funds, and make sure you save and invest regularly. Do it automatically, and then forget about it. Appreciate that you need to be patient and will not get rich overnight. Make it as simple as possible and don’t aim to beat the market.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.