The Simple Way to Make Money on Stocks

Much has been said about how to make money from stocks, but one paper reveals how great wisdom from Warren Buffett is something we all need to do.

Aug 18, 2014 at 8:00AM

Buffett

Looking for how to make money in the stock market? A new paper reveals there's one easy way.

And it turns out it's one thing Warren Buffett has admitted he does almost every day.

The importance of saving and investing
According to a recent paper released by the National Bureau of Economic Research, or NBER, entitled Financial Knowledge and 401(k) Investment Performance, now, more than ever, the ability for an individual American to properly save and invest is critical.

Images

Source: Flickr / 401(K) 2013

The paper notes that as a result of the changes in how employers contribute to employee retirement accounts -- pension plans have become less common and things like 401(K) accounts, which require more decisions from individuals, have grown -- "the ability to invest wisely and earn better returns will therefore be increasingly critical for national retirement well-being in an aging world."

In other words, there has never been a time quite like today when an individual's responsibility to manage their retirement has been so important.

And after pouring through the retirement accounts of more than 22,000 individuals and surveying thousands, the study found there is in fact one thing that can ensure success is had in investing.

The key to success
The answer? The paper went on to say:

Our results show that more financially knowledgeable investors earn substantially better risk-adjusted investment returns. Specifically, expected risk- adjusted annual returns are 130 basis points higher for the most financially literate investors, as compared to the financially unsophisticated. This advantage could have important implications over a lifetime of saving for retirement, and it might help account for large differences in retirement wealth in the population.

In other words, the more an individual knew about finance, the more they earned from their investments. And to put that into context, the difference of 130 basis points -- or 1.3% -- annually may not sound like a lot, but it can make a monumental difference over the course of a career.

A powerful example
Consider the examples of two 25-year-olds, Jerry and Larry, who each made $40,000.

They started work at the same time, and they each saved 5% of their income into 401(K) plans where their 5% contribution was matched by their employer. So they put away $2,000 of their own money in the first year into their 401(K) plan and the employer added another $2,000 into the account.

Let's also say their salary grew by 3.5% each year, and they worked for 40 years before they retired. As a result, they would've built up more than $350,000 thanks to their savings and their employer's contribution. Not bad!

But of course, it would be one of the most dangerous things to not invest those savings and let it just sit in an account.

So they both invested, but Larry diligently tried to become more educated about finance. But regrettably, Jerry didn't. As a result, Jerry earned 7.5% each year from his investing, but as the study would suggest, Larry was able to boost his return by 1.3%, netting him 8.8% annually.

So what would that mean over the course of 40 years? Words don't do it justice:

The Difference In Retirement From Learning
Source: Author Calculations. 

Despite identical savings put in, when they retired, Larry would have nearly $650,000 more than Jerry thanks to the higher returns.

And this is even despite the fact the study notes, "our estimates of the positive association between financial knowledge and investment returns may be understated." Meaning that difference could be even higher.

The Warren Buffett wisdom
Warren Buffett is undoubtedly one of the greatest investors of all time. From 1965 to 2013 the book value of his firm -- Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B) -- has grown by 19.7% each year, whereas the S&P 500 delivered a return of 9.8%.

That difference of nearly 10% each year means $100 in his firm nearly 50 years ago would be worth $693,518 today, whereas $100 placed in the S&P 500 would be worth $9,841.That is all to say, beating the market is a gross understatement. 

But he once said: 

I insist on a lot of time being spent, almost every day, to just sit and think. That is very uncommon in American business. I read and think. So I do more reading and thinking, and make less impulse decisions than most people in business. I do it because I like this kind of life.

He is clearly one who understands the value of reading and thinking, which leads to better learning and investing.

At times we can think the only way to make money is to have money, yet we must see, when it comes to investing, the key to success isn't the money we have, but understanding what to do with it.

Warren Buffett: This new technology is a "real threat"
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Patrick Morris owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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