What You Need to Know About the Stock Market

stock market fear.jpg

When speaking on a radio broadcast in 1939, Winston Churchill made the following comment about Russia and its national interests:

"I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma..."

When I talk to people about investing--especially in the stock market--I get the same kind of vibe. The stock market feels so complex, puzzling, and unpredictable, that the lack of understanding fosters a distrust of it, and lack of willingness to participate.

The stock market feels so complex, puzzling, and unpredictable, that the lack of understanding fosters a distrust of it.

Just as there are “many roads to Dublin,” there are many ways to build wealth over time. For many of us, the stock market is one of the most accessible, cost-effective methods of doing so, if we can understand it better.

In this post I’ll take a few minutes to explain how the stock market works, address some common concerns, and hopefully help you make a more informed decision about participating in it.

What is the stock market?

The stock market is really like any other market. When you go to the grocery store, you are greeted with a wide variety of items to purchase. You are buying and the store is selling. You make purchases based on your needs, dietary constraints, how much money you have, etc.

The stock market is also a store where people buy and sell, but instead of food they’re buying and selling ownership of companies--thousands of different companies--represented by company “shares.” There are physical stock markets, also called exchanges, but stocks are mostly bought and sold electronically.

So if you wanted, you could open an investment account online, put some money in it, and buy shares, or stock, in a company--Apple, Chevron, Facebook, whatever you fancy. It’s important to understand that buying shares of stock literally means you are buying a little slice of ownership of that business.

The stock market is scary

Fears around the stock market typically center on the fact that it can unpredictably move up and down in value, and one can literally see the market’s value at any given time. Why does the market move up and down? Let’s go back to our grocery store example.

When the grocery store gets a huge supply of seasonal fruit, like peaches in August, they typically sell them at a reduced price. Why? Because the supply is high, and the number of buyers willing to purchase them is relatively lower.

When a stock increases or decreases in value, it’s a reflection of the supply of that stock. If the “supply” is low, it means demand for that stock is high, so the price increases. If demand is low, the price decreases. At any time during the day you can see whether a particular stock is up or down in value compared to the previous day.

Stocks move up or down in value depending on news about that stock--like Apple having great earnings following the release of a new iPhone. But when people talk about the stock market, they are typically talking about the overall performance of the market.

 The S&P 500 performance over the last 10 years. Increasing over time but with many ups and downs. (Note: Past performance of the stock market does not guarantee future results.)

The S&P 500 performance over the last 10 years. Increasing over time but with many ups and downs. (Note: Past performance of the stock market does not guarantee future results.)

In 2007, due to the financial crisis, our economy was officially in a recession. The economy slowed down--fewer goods were being bought, fewer homes built--and as a result companies on stock exchanges lost value. Between 2007-2009 stocks lost nearly 50% of their value. Some individual stocks did better and some worse, but on average the overall market decreased by 50%.

While economic recessions occur regularly and are normal (even necessary), they have a tendency to scare us for a long time, even after the recession has passed (which ours did in 2009) and stock prices have begun again to increase in value.

Is stock market investing just gambling?

With the fears that stock market investing can foster, some may dismiss investing as a gamble. Depending on how people behave with stock investing, this may be right conclusion (I’ll explain).

Many investors try to pick winning stocks by doing their own research (or “gut guessing”) into which companies will do better than others. Investor behavior like this is a pretty sure way to gamble away your investments, and lose. The stock market is extremely difficult to predict, even for the pros.

Fortunately, the stock market is different than the roulette table, where after many attempts the house always wins. With the stock market, in theory all participants may be winners over time, if they play by the right rules. While there’s no guarantee that the stock market won’t go down in value, a primary reason the stock market has increased in value over time is that businesses--not just in our country but in others as well--have an incentive to increase productivity, decrease costs, and innovate. As businesses do this, the economies that are made up of those businesses improve as well.

You must diversify your investments

If stock picking isn’t the right way to invest, what is? By accepting that even the professionals struggle to pick winning stocks consistently, investors are better off buying a share of the entire stock market. This is most easily done through purchasing a mutual fund, which is an investment that buys hundreds or even thousands of different stocks for you automatically.

Mutual funds can decrease the risk of owning one or two investments through diversification. If one of those investments had a sudden drop in value, you could lose a big chunk of your overall portfolio value. With a mutual fund, the sudden drop in value of a stock in that mutual fund will have minimal impact of the fund’s value overall.

 Undiversified

Undiversified

 Diversified

Diversified

Diversification doesn’t remove the risk of the overall stock market going up and down in value, but it does remove the risk of losing your entire investment by putting all your eggs in one or two baskets.

Diversification is most easily accomplished in the stock market through mutual funds.

I hope this article has shed some light on how the stock market works. It doesn’t have to be “a riddle, wrapped in a mystery, inside an enigma." Investing in the stock market is not without its risks. Some risk must be accepted to earn a reasonable return.

Market ups and downs, and even recessions, are common and expected over time, but they’re scary too. Making a plan for investing over the long-term can give you confidence that you can withstand the ups and down and hopefully increase your wealth over time.