The stock market isn’t that complicated, but it can be intimidating if you don’t understand the basics. It’s important to know this if you are saving for retirement, for college or any other reason. Here is a very straightforward explanation of how it works.
Think of the stock market as you would any other market. Do that because that’s exactly what it is. In fact, when the stock market began back in the late 1800s, it was very similar to a flea market.
Entrepreneurs who needed money to grow their business would pin up advertisements and offers on trees. (Ever wondered where the expression “Money Doesn’t Grow on Trees” comes from? Now you know.)
People who had money to invest would read these offers and negotiate with the owners of the company who stood by the trees where they had pinned up their offers. Investors negotiated and exchanged their money for partial ownership of the business. The investors received shares of the company in exchange for their money. That concept remains in effect to this day.
Why do some stocks go up in value over long periods of time?
Earnings. That’s the only reason. Over the long run, if the business earns more money, the business is worth more. That being the case, the shares that represent ownership rise in value. But if the earnings of the company fall over the long term, the value of the business drops and so will the price of the shares.
Think about GM. Over a very long period of time, GM’s profits dropped. In fact, those profits turned into losses. Those losses didn’t turn around so the value of the company (and the shares) dropped and kept dropping until the company went bankrupt. If you were an investor, you lost almost everything because the company wasn’t able to make a profit.
But if you invest in a company that is able to grow their profits, the value of the company will rise over time and so will the price of your shares. Think about Microsoft in the 80s and 90s. Think about Apple right now. These are great companies because they make products people want and the company can sell those products and earn a tidy profit. That profit goes to the people who own the company in the form of dividends or reinvestment into the company. That doesn’t matter so much. What matters is that the company earns a healthy profit and, as a result, the value of the company rises.
What about the short run? The short run is a completely different story. Over the short run, the stock market is an emotional and violent place. But it’s still a market. It’s all based on perceptions, fear and greed. It has almost nothing to do with reality (i.e., earnings).
Over the short run, if people are afraid of the future, values of shares will drop even if the company itself is fantastic. If investors think that it’s going to be harder for companies to make a profit, they won’t be interested in owning those companies. They’ll sell shares. And if investors panic, they’ll sell at any price.
Have you ever seen the price of a stock rise or fall by 10% in a single day? Can the value of a company really change that much overnight? Well it could, but that’s rare.
No. In most cases, short-term price changes have everything to do with the fears and greed of people based on what they think the future holds. Short-term prices have very little to do with the value of the company.
Over the long run, it doesn’t matter what people think or fear: earnings determine price. Over the short run, it may not matter what the earnings are, people’s emotions determine price.
How do you use this information?
That’s the tough part. It’s easy for me to tell you to buy great companies and forget about the short run. It’s great advice and very easy to say but very difficult to do. Everyone gets emotional. You can’t help it. You’re only human.
If you invest in the stock market, you have to be aware of this dynamic. You must understand the difference between the short run and long run. Finally, you must find an investment strategy that allows you to make money over the long run and not get shaken out of your strategy by the violent and emotional swings of the short run.
What is your approach to investing in equity? Are you a trader? Do you use a methodology? Do you buy and hold and forget it? (For a different approach, read the Ivy League portfolio.)