Many newcomers to the stock market seem to gravitate to penny stocks like moths to a flame. I was once one of them. Let me tell you about my experience, about why such stocks can be bad for your wealth, and how I came to see investing in the blue-chip FTSE 100 as a far saner way to aim to get rich.
From betting ring to stock market
Many years ago, I started my working life in the world of horseracing. Specifically, I worked as a private handicapper, form-guide writer and tipster for a small company that provided data and analysis to a number of national newspapers and racecourses.
Handicapping horses is part science and part art. With full-time focus, skill and discipline, it was possible — in those days, at least — to identify and profit from valuation anomalies in the betting ring. However, I came to learn that the stock market offers a much simpler and surer way to build your wealth. In the beginning, though, I didn’t get it.
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Penny stocks
When I first took an interest in the market, I naively assumed that all one had to do to make money was buy penny stocks with good stories promising massive future profits, and wait for their share prices to multiply. Today, on financial discussion boards around the web, I see many novice investors similarly drawn to the apparently life-changing potential of such stocks.
However, even if the company directors aren’t hopeless over-optimists, or as interested in feathering their own nests as anything else, or even occasionally outright fraudsters, the typical lack of cash flows of ‘blue-sky’ stocks and serial dilutive fundraisings are often ruinous for shareholders.
Fortunately, I learned quickly that simply putting money into ‘story stocks’ with uncertain assets and no cash flows didn’t cut the mustard as an investment strategy. Indeed, it was far riskier than backing horses from a position of knowledge and with a disciplined focus on valuation anomalies. Punting penny stocks, in my experience, was more akin to going to a casino and simply playing the roulette wheel until you’d blown all your cash.
FTSE 100
It was reading books about investing that opened my eyes to what the stock market really has to offer. Main markets, such as the UK’s FTSE 100, contain established, profitable businesses. In contrast to blue-sky penny stocks that are constantly asking investors for more cash, blue-chip FTSE 100 companies generally pay you cash (via annual dividends) for owning their shares. And because many of these companies increase their profits and dividends over time, the value of their shares also increases.
A simple way to enjoy these fruits is to invest in a low-cost FTSE 100 tracker fund. Effectively, you’re buying a small stake in every business in the index. If you’re looking to build a nest egg, you can buy the ‘accumulation’ version of the tracker, which automatically reinvests the dividends to buy you more shares. If you want the dividends as cash — say, to enjoy a higher-quality lifestyle in retirement — you can buy the ‘income’ version of the tracker.
Historically, the FTSE 100 has delivered a long-term, average total return (capital increases plus dividends) of around 7% a year. It’s a far saner way to get rich, in my opinion, than gambling in the flaky world of penny stocks.
