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Walk around and ask some random people about stocks, and you’ll hear a lot of “I bought this stock at $5 and then sold it when it got to $10 and made $10,000!” or “I bought this stock at $5 and now it’s so low I don’t want to look at it”. These are people who sell when the stock is up, and hold on when the stock is down. At least, this seems like how most people interpret “buy and hold”. It seems strange though. Are they selling based on how much they’ve made/lost? Or based on the price of the stock? Or based on the news that everyone knows? How exactly does that make money?
To see what a good stock is, we should start by examining where the money in the stock market comes from. Afterall, if you’re going to make money, you should know where the money is coming from so that you can be secure in knowing it’ll keep coming! In its simplest form, a stock is a just a piece of a certain business. They’re giving you a piece because you’re giving them (theoretically) an equivalent amount of money so that the business can be expanded. This piece can then be resold to other people as you please.
Then the question becomes, how do businesses make money? Well, we can start with the articles Do You Get Money and How To Come Up With A Good Business Idea. When it comes down to it, business make money because they make a product or provide a service to someone that is worth more than the money being paid for the product/service. This is the basic concept of creating value. Two entities have something each other want; they exchange and are both better off. Say each person has $500 worth of stuff to trade. After the trade, each person now has $1000 worth of stuff to trade. That’s the power of a good trade – that $1000 of value just appears out of thin air.
Compare this with a business that tries to hammer out some sort of small edge. For example, walking around all day looking for loose change can be considered a business (or maybe looking for cans, or begging people for money). In this business, not much value is created, except maybe some minor garbage cleanup. Therefore, after you’ve picked up some guy’s change, he’s not going to come back to you and say, “Oh, please, here’s some more change that I’d like to drop so that you can pick up”. The problem is the “fixed pie”. In order for you to gain a nickel, somebody has to lose a nickel. Well, people only have so many nickels to lose
However, in a more mutually beneficial environment, when you give up a nickel, you get two nickels worth of stuff back. Now, you can turn those two nickels worth of stuff back into nickels, so you can get 4 nickels worth of stuff. That’s when your customers keep coming back for more. It’s like nickels dropping out of the sky. Where do these nickels come from though? Well, whatever it is you’re doing that’s turning those 2 nickels worth of stuff into 2 actual nickels, that’s something somebody values. Otherwise, they’d just go to the guy you’re getting the 2 nickels worth of stuff from, and do it themselves. That’s the extra money from the value you’ve created (which you’re getting the big part of). Why wouldn’t your customers keep coming back? They’re getting all that “free” value just like you are!
Now you know what kind of business you should invest in. Take a look at the business model of the company behind the stock. Is it creating real value for the people who buy the product? Are they happy with the money they’re paying for it? Will they come back for more? Listen to the CEO when he speaks. Is he dedicated to bringing their customers more value, or just interested in making the stock price goes up while he cashes out?
On that note, remember that stocks that have lots of news releases and updates aren’t necessarily good stocks, especially if they’re small. Sure, they’re keeping wall street well connected so that their stock price is of fairer value, but wall street isn’t their customer! What good is it to know exactly how much money the company is making if they’re on their way to being bankrupt? I’d rather have a big surprise every couple of years where they tell wall street, “Oh, by the way, we’re actually making 3 times what you expected”, and the stock price shoots up. Money made is money made whether wall street knows about it or not. I’d rather they focus on their customer relationships than on wall street relationships.
Once you’ve found such a company, just make sure the price isn’t ridiculous, and put your money in. Then, don’t look at it again for at least a year. You bought the company because it’s creating value remember? A week from now, it’s still going to be doing just that, so don’t worry about it. Just go do something else and let that extra value build up!
I’ll further elaborate on when to sell in Why You Should Invest For the Long Term.
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