We all know that the stock market has been making substantial gains lately, and it is not difficult to find some stocks, particularly the blue chips, that we have bought some time ago doubled itself in the share price. In other words, it is a 2x bagger. Well, impressive, isn’t it? We made 100% in capital gains. And it has not included dividends that have been distributed along the way.
Let us take a hypothetical case. Say we bought 1000 shares of a stock costing $10 per share. For the purpose of simplicity, we assume that the stock price increase 10% a year arithmetically. In other words, we bought the stock at $10 per share at the 1th year, but we stopped there and let the price run. By 2nd year, the stock price reached $11, then $12 at the 3rd year and so on. This carries on till the 11th year when the stock reached $20, which would have been a 2x bagger. In all the passing years, we received dividends equivalent to say about 3% of the stock value per year. Given that the share price increases arithmetically, the quantum of the dividend should also increase correspondingly. (In real situations, we do not expect that to happen in lock-step increment, but generally when the stock price increases due to the better fundamental of the company, the management generally moves up the dividend as well to align the dividend yield with the increasing stock price.)
So, based on the calculation, by the 11th year, we would have made a capital gain of 100%. If we add in the dividend, the gain would have been a whopping 149.5%, of course without taking into the time value of money. Very good situation, indeed.
Now we take the situation a little further. Instead of purchasing 1000 shares of the stock and stop there, the investor continued to buy the stock consistently. There are, of course, infinite possibilities of buying and selling the stock and we cannot possibly include all the possible scenarios in this discussion. But given that the stock price continues to move up due to its underlying fundamentals, a likely situation would be that he has to buy the stock at higher and higher prices in the whole time-frame of 11 years. Let us just take a situation that he bought the stock according to the increasing stock price of 10% increment every year in line with the average price of 10% increment in the stock price per year. At the end of 11 years, his capital gain would be $55,000 out of a total outlay of $165,000 or 33.3%. Sure, it does not sound as impressive in percentage term as the 1st case when he made 100% gain in capital gain. But in absolute sense, his capital gain of $55,000 would have out-beaten the earlier situation with capital gain of $10,000. By including his dividend of $33,000, his total gain would have been $88,000 compared to only a mere $10,000 in the 1st case.
Why am I making a case study of comparing the two scenarios? Very often, we think of making 2x bagger and 3x baggers that we forgot that making consistent investments may help us more in absolute sense in the long run than just in percentage terms. Especially when we have consistent income coming in, it makes good investment sense to invest consistently, and even to the extent of disregarding the stock price, to create the investing discipline. Timing the market to try our luck and make sudden gains make us very happy, but building our wealth through consistent investing is the key to financial success. What is the purpose of buying a stock and make a 3x bagger but the ‘new’ monies that comes in go to the bank to yield paltry interest.
But that said, it is important to note that overall outlay in the 2nd case ($165,000) is much higher than the 1st ($10,000), but it is still better than leaving the balance of $155,000 doing nothing. Worst of all, to put it in ‘investments’ that do not yield returns or even negative returns. It is also important that it requires a lot of discipline to consistently buy stocks at higher and higher prices. Psychologically, it is not easy to do so. Our mind is conditioned to buy things at discounts than to buy them at a premium, let alone buying them at increasing price each time. A lot of people lost money in investments is more because they bought wrong stocks at ‘discounted prices’ than people who bought the right stocks at ‘premium prices’. Investing requires several traits that work hand-in-hand – (1) do our homework to buy the right stocks, (2) discipline to hold the stock and even increasing the quantity, and (3) the mental fortitude to ride through the adversities.
The writer is not a fund manager to invite investors to buy into his fund. He is taking a neutral stand to look at how we should manage our investments.
Brennen has been investing in the stock market for 28 years. He trains occasionally and is a managing partner for BP Wealth Learning Centre. He is the instructor for two online courses on InvestingNote – Value Investing: The Essential Guide and Value Investing: The Ultimate Guide. He is also the author of the book – “Building Wealth Together Through Stocks” which is available in both soft and hardcopy.