economicmultipliers_147

Economic Multipliers (147)  
 
Do you know what these are?
They help CREATE wealth in systems.
Understanding volatility in the stock market is an economic multiplier if you ever invest (even indirectly) in stocks.
           
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This could be entitled:  Why it’s easier for wealthier people to make money.

Since I think wealthy people and making money are good for economies, appreciate that these are just things to think about if you are and/or grew up ‘grounded’ and would like to imagine how different life is for individuals who don’t have the same kind of ‘grounding’ or income.

As an example, if you have a fair amount of money/equity/income, it’s likely that you don’t have to pay for your trades at a brokerage house OR you pay a lot less (on a percentage basis) than a person who has less.

If you bought 10 shares of a stock and the transaction cost was $7.00, you’d have to make 70 cents per share on the stock just to break even.  Since there is also an exit cost, it would be better to factor in $14.00 (or $1.40) to break even.  An individual who buys 100 shares has 14 cents per share to make up for.  An individual who buys 1000 shares only has a per share transaction cost of 1.4 cents to make up for.

Of course, if you buy 10 shares and the stock drops by $1.00, you’ve only lost $10.00.  If you buy 100 shares, you’ve lost $100 and if you buy 1000 shares, you’ve lost $1000.
  • If you buy 10 shares that cost $700 ($70 per share), that $14 transaction cost is 2 percent of the investment.
  • If you buy 10 shares that cost $70 ($7 per share), that $14 transaction cost is 20 percent of the investment.
  • If you buy 10 shares that cost $7 (70 cents per share), that $14 transaction cost is 200 percent of the investment.
If you have extra spare cash on hand, when the market goes down, you can buy shares at reduced prices.  For the same amount of money, you get more shares.  If the stock pays a dividend, the lower priced shares have a higher rate of return and because you have more shares, you get more dividends.  If the stock price then goes back up, you have more equity and because you have more shares, you have more equity in more shares.

An individual who has long-term investments might be satisfied to only hold preferred stocks … stocks which tend to trade within tighter ranges (less volatility) than common stocks.

Preferred stocks:
  • are somewhat similar to bonds (with less protection than bonds and more protection than common stock if a company gets in trouble),
  • pay a fixed rate of return,
  • many times are cumulative in nature … if the company runs into a spell of bad luck (that does not continue), the dividends are paid at a later date,
  • may be callable … if bought at a price above the face value and the shares are called, you can lose the difference in price, and
  • may be convertible … if the common stock price jumps, the common stock might have greater value to an investor than the preferred stock.
Stocks can have huge swings in prices and recommendations by ‘experts’ aren’t always a good measure of success.  Not only is it important to analyze the strengths of the companies you invest in, it’s good to read old articles about whether someone ‘predicted’ whether the stock price would go up or down (and compare the ‘analysis’ against results).

In a perfect world, stocks would not be so volatile and returns on investments would be stable (predictable).

In a less than perfect world, it is possible to watch a preferred stock with a par value of $25 which pays 7.625 percent drop in price to under $20 in a matter of months due to industry problems and then recover in the same short time to the $22-$23 price range.

If the company survives and thrives as the industry recovers/adjusts, the preferred stock will continue to pay its dividend … $1.91 per share annually.  If the dividend is ever suspended, you could expect the stock price to fall again.  If the company ever fails, you might lose your initial investment.

For a $2500 (+ trading costs) investment (your ‘cost basis’), these are the differences when people make investment choices at different times:
  • At $25 per share … 100 shares … $190.63 in dividends per year (a return of 7.6 percent)
  • At $20 per share … 125 shares … $238.28 in dividends per year (a return of 9.5 percent and 25 percent more dividend income annually)
If the investor at $25 per share ever needs/wants to sell at a price of $22.50, they will have lost $250 on their core investment (plus transactions costs) … a 10 percent loss.

If the investor at $20 per share ever needs/wants to sell at a price of $22.50, they will have gained $312.50 on their core investment (minus transaction costs) … a greater than 12 percent return.

The investor looking at a greater than 12 percent return might take that return (and any dividends already accrued) and use the money to purchase some other stock that seems to have abnormally slid in price … once again looking for higher returns.  The investor with the loss might feel compelled to hold the stock, knowing that if the stock price does not recover prior to their selling, they will have earned any ‘dividends’ but their overall rate of return will be lower than 7.6 percent and they might even lose money.

Either investor might ultimately need the cash that the stock represents.  It’s preferable to be selling with a gain and the use of that money represents an ‘opportunity cost’ … it could have been used for something else.

When individuals have long-term investments (many times with corporations making those investments for them), they may be unaware of how volatility can affect their long-term returns.

Individuals who are able to strategically get in and out of the stock market as markets shift (because they have the ‘grounding’ … the wealth/income … to do so) are in a much better position to make money in the stock market than the average person.

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Years ago, when you invested in stocks, it was more likely that you were truly investing in companies.  The ‘stock’ represented the capital that a business needed in order to be in business, make money and grow.

Dividend reinvestment programs provided ‘extra capital’ for companies to grow.  Today, if you get involved in dividend reinvestment programs (DRIPs), the company itself might buy the stock on the open market:  It does not need the capital or if it does, debt might be less expensive.  That changes the ‘relationship’ a company has with its stockholders.

Individuals with wealth usually know that it’s good to invest in things which retain value and preferably earn a rate of return … things which preserve and grow wealth.  Keep in mind that this is a good attitude for everyone because property taxes, sales taxes and income taxes support a lot of things.

Just never let anyone tell you that everyone has the same opportunity to make money in the stock market … or anywhere else for that matter.