How the Stock Market Works

In my last post, we defined two criteria that are desirable in an investment: performance and convenience. We saw that the stock market fulfills both of these criteria, with incredible performance and, if done correctly, also incredible convenience. So today we’ll talk about how the stock market works.

What is the stock market?

The stock market is a collection of about 3,700 publicly traded companies in the United States. Other countries also have stock markets containing publicly traded companies, but here I will only discuss U.S. stocks. When you buy stock in a company, you literally own a fraction of that company equaling to your shares divided by the total number of shares. And when your company profits, those profits are passed on to you in the form of dividends or reinvested back into the company in the hopes of even greater future profits, ultimately driving up the value of the company. The value of the company (price per share multiplied by number of shares) is decided by the market (i.e. just a bunch of people who buy and sell the stock) and is called the market capitalization. If the company is especially productive, or is expected to be productive in the future, it will be in high demand. Thus, many people will buy shares of this company even if they are “expensive1A common way to measure how “expensive” a company is is by the price to earnings (PE) ratio. This is calculated by dividing the share price by the annual earnings per share (total earnings divided by number of shares). Slow growing, stable companies often have lower PE ratios (e.g. Ford ~6.2) while fast growing companies have higher PE ratios (e.g. Amazon ~316) <- that’s an extreme example.” relative to the current earnings of that company. Similarly, if a company is doing poorly or is expected to do poorly, its share price will be relatively lower.

How can we invest in the stock market?

In general, there are two main ways you can invest in the stock market. The first way is buying individual companies. A proponent of this method might argue that you can just look for either companies that appear to have a bright future, or companies that are currently undervalued relative to their earnings. The second way, brought to you by the awesome technology available to us living here in the future, is to just buy the whole market. Certain investment companies, like one called Vanguard2This company is especially beloved by most serious investors. It is known for it’s extremely low fees and its founder, John Bogle, who is pretty much the grandfather of index investing, which we are talking about now!, have a ton of money. They take this money and create “funds.” Vanguard, for example, has what’s called the Total Stock Market Index Fund. Essentially, they take their huge pool of money and buy some of every single company in the whole market, with the amount of money in each company weighted by its market capitalization. For example, if Apple is worth twice as much as Johnson & Johnson (I have no idea if this is true), the Total Stock Market Index Fund will have twice as much Apple as J&J. There are a couple different ways to buy this fund (they are all very similar), including an Exchange Traded Fund, or ETF. An ETF basically trades like a stock—you can buy “shares” of it—but the share price represents the value of the underlying companies within the ETF. Vanguard’s Total Stock Market ETF is called VTI, and from here on out I’ll just refer to buying VTI and buying the whole stock market as interchangeable things.

Ok, enough details: Which way is the better way? That’s easy! The second way. And it’s not even close. Long-term studies of active funds (like this one), in which “professional” humans are actively deciding what companies to buy and sell and when to buy and sell them, have shown that these funds underperform the total stock market in something like 99 percent of cases. Individual investors don’t fare any better. 99 percent! Isn’t that a little bit funny? There are all these financial people out there being paid big bucks to manage all these other people’s money, and YOU, just an average Joe or Josette, can literally beat almost all of them at their own game by just simply buying VTI. What a world we live in!

Why People Stink at Picking Stocks

Why is everybody, both individuals like you and me as well as people who are educated and paid to do this, so bad at picking stocks? As it turns out, even with lots of schooling, fancy technology, and detailed analysis about what the proper value of a company is, it is still very difficult to predict the future. Furthermore, even if you could predict the future, as long as everyone else knows the same thing you do, you still won’t profit. If you know a company will do well in the future, and everyone else does too, shares of that company will be instantly bought up on computers faster than yours and the new very expensive share price will reflect the future profitability of the company. So unless you have secret inside information (which is illegal), or somehow get information that you can act on before everyone else does, or are smarter than every single person investing in the stock market—including people poring over each company’s financial details for hours and hours—you’re basically playing a guessing game. Some people are wise enough to realize this, but figure they can beat the market by paying the experts to pick stocks for them. The problem is that not only do these experts also not know how to predict the future, but they charge fees that are often in excess of 1 percent3ETFs like VTI also have fees associated with them, but they are very low, like on the order of 0.04%. This fee is embedded in the cost, so you won’t really see it when you buy shares of VTI.. That may not seem like a lot, but compounded over many years it is a huge effect that crushes whatever remote chance those people had of beating the market.

So why are “professional” money managers still in business? Not only are they still in business, but they are thriving. And not only are the “pros” still in business; regular people like me and you actually try to compete with them, buying and selling individual stocks trying to beat the market! People are greedy, and people are silly. Apparently, the somewhat boring idea that a passive, no-brainer approach to investing is best doesn’t really sell well. Additionally, there are lots of financial “experts” out there whose livelihood depends on making you believe that they can beat the market, and that by paying them your money you can beat the market, too. Because of this fact, they will go to any length imaginable to make you believe this. This includes, but is not limited to, reporting their performance based on cherry-picked time frames in which they outperformed the market for a short time, sending opposing “predictions” to different groups of people and then targeting the sub-groups who received accurate predictions, and many other forms of deception.

For the individual investor, the ego also plays a very big role, and getting rid of an investing ego is probably the most useful thing any investor can do. Intelligent people especially have trouble with the fact that they can’t do better than the “average” of all the companies in the market (even though being “average” really puts in you in the top 1%). In your adult life, you will come across friends and colleagues who believe they can pick stocks, despite the mountains of evidence that fly in the face of that belief. This is why we’ve spent four paragraphs hammering home the idea that just buying VTI is the way to go. As a fancy and successful individual (as all of our readers are), you’ll be surrounded by garbage advice and investing tips. You’ll get mail or cold calls about it. Your colleagues will tell you about this new company they’re investing with and how they’ve been crushing it for the past several months. But in the long run, the intelligent investor backs their investment decisions with cold, hard facts and doesn’t get distracted by nonsense “advice” or anecdotal evidence. And lucky for us, we can take further comfort in the fact that this superior approach requires almost zero effort! We buy VTI, we hold onto it as we keep buying more of it, then we become financially independent. Now that’s convenience!

 

“It seems counterintuitive that the masters take a humbler approach than amateurs. But we see it all the time.”

– Morgan Housel, partner at The Collaborative Fund and a really good follow on Twitter (@morganhousel).

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