What is the Stock Market and Why Should I Care?

My little brother told me that he “doesn’t believe in the stock market.”

I was a bit confused by his comment, “Huh…you don’t believe it the stock market? What do you mean? It’s not like Santa Clause or the Moon landing.

The stock market exists, there isn’t much room for debate.”

What I think my brother was trying to articulate is that he doesn’t understand the stock market. He doesn’t get what it is or how it works.

He see’s the stock market as a place where only the ultra wealthy participate. He sees the stock market as something that he can’t afford and this makes him feel excluded. And, because he feels excluded he’s made no effort to participate.

This is a very costly decision.

My brother is a super smart guy but he claims to think that money is evil.

I don’t know where he gets this, and I don’t know how we came out of the same house with such extremely different views on money.

I think my brother says that he “doesn’t believe in the stock market” and he “thinks money is evil,” for two reasons:

1. A lack of understanding, aka, a lack of financial literacy
2. Confirmation bias…

…Let me explain

Confirmation bias is defined as, “the seeking or interpreting of evidence in ways that are partial to existing beliefs, expectations, or a hypothesis in hand.” (1)

In other words, you look for evidence to reinforce the beliefs that you already have.

For example, if you believe sexual orientation is “a choice” you will look for resources that will reinforce this belief (e.g. the bible) and ignore evidence that suggests otherwise (e.g. science).

My brother is an extremely talented musician BUT, he is still in the “starving artist” phase of his career. He idolizes musicians that didn’t “sell out,” he reads books about artists that died poor but got super popular once they were gone.

He actively seeks information to support his claim/confirm his bias that “money is evil” and that the true musicians aren’t in it for the cash.

If he can confirm that money is evil then he doesn’t have to feel bad about not having any.

Sorry bro.

Maybe you don’t hold the same bias about money as my brother… neither do I. But, I think it’s safe to say that he’s not alone when it comes to a lack of understanding about the stock market.

It’s a very abstract concept.

So, let’s break it down and try to make sense of it.

What is the Stock Market and Why Should I Care?

Stock: you can think of a stock as a piece of a company.

Market: a market is a place where people go to buy and sell goods.

Put them together and you get “stock market,” a place where people go to buy and sell pieces of a company.

Why does the stock market exist?

Companies generally decide to sell stocks (pieces of their company) in the market when they are looking to expand (e.g. hire more people, acquire more resources, do more research and development).

Expansion requires capital (a.k.a MONEY). So, they go to the market in order to sell pieces of their company (stocks) which the public (you and me) can purchase with out hard earned money.

Selling stocks benefits the companies by allowing them to gain capital and expand.

Buying stocks can benefit the purchaser (you and me) by potentially growing our money.

As a whole the stock market has continually risen in value throughout history.

This is due to factors like an ever growing population (more people = more workers = more people to participate in the market) as well as technological progress and productivity (increased technological progress = increased productivity = increase in economic activity).

If populations continue to rise and we continue to be productive then the market should continue to rise. This is likely, but not 100% guaranteed.

When it comes to individuals stocks there is no guarantee that they will rise overtime. Individual stocks tend to continually rise and fall.

This is why the majority of academic research suggests that you should buy a chunk of the entire stock market (i.e. an index fund) vs. trying to beat the market by purchasing individual stocks (i.e.bitcoin). There’s a lot more risk and volatility associated with individual stocks.

An index fund is an investment fund that tracks the performance of an established set of stocks.

In other words…it’s a bucket of stocks that replicates a pre-established part of the market.

A very popular index fund that you may have heard of is the Standard and Poor 500 (S&P 500). This index is made up of 500 of the most widely followed US companies. The S&P500 acts as a measure of how the stock market is doing in general.

From a Canadian perspective we have the S&P/TSX Composite Index which includes ~250 companies.

When you buy an individual stock you are buying a small piece of an individual company. Investing in individual stocks is riskier than investing in an index.

The main reason is that you have less diversification. In other words, all of your eggs are in one basket.

When it comes to investing, don’t put all of your eggs in one basket

When you buy the S&P 500 or the S&P/TSX Composite you are diversifying across 500 companies. Meaning, you have your eggs spread into many baskets.

When you buy one stock you are buying ONE stock. So, if that stock goes way down then you are screwed.

There are many other reasons why individual stocks can be risky but I will save that for another post.

Let’s keep moving along!

Why should I get involved in the stock market?

I already mentioned the reason to get involved with the market — the potential to grow your money.

Think about this in terms of your retirement.

I don’t know about you but I’m not counting on a company sponsored pension. I know that if I want to have a comfortable standard of living when I retire then then I have to invest my money.

If your current retirement savings plan is to hoard all of your money in a regular savings account or, even worse, stuff it under your mattress, then think again. With these plans you are actually losing money each year making it harder to realize your dream of one day retiring.

You might read this and think, “Bitch, you crazy. How could I lose money by socking it away in my mattress?”

Well, I’m glad you asked.

The reason is called INFLATION.

Inflation occurs when the cost of living increases (e.g. housing, transportation, food) and, as a result, the value of money decreases.

For example, we see inflation in action when the cost of a banana that was $0.40 in 2017 has increase to $0.55 in 2018. This increase might be due to increases in the cost of fuel which makes it more expensive to transport the bananas or a rise in rent that makes it more expensive to store the bananas prior to shipping. Here we see the cost of food has increased.

In 2017 you could go to the store with $1.00 and purchase 2 bananas. In 2018 that same $1.00 will only get you 1 banana.

**Note, this example is not based on actual rates, it is merely an example to demonstrate the elements of inflation.**

Here we see that the value of our money has decreased. One dollar will no longer get you 2 bananas.

Let’s say the rate of inflation is 2%. If your money is in a savings account making 1%, or worse yet if it is under your mattress making 0%, then you are losing money.

On the other hand, if inflation is 2% and your money is invested in the stock market making an average return of 10% then you are netting an 8% return (not counting any fees).

The moral of this story — get your money invested and working for you.

Investing in the stock market sounds scary

I get it. The stock market can be scary if you don’t understand it. The stock market can also be scary if you kind of understand it (this is where I’m at).

As someone who is fairly risk averse, I find it hard not to think about all of the bad things that could happen to my money when it’s invested.

What if there is another stock market crash right before I retire (importance of diversification). What if there is another epic 1929 style crash and we go into another great depression (if this does happen we’re all fucked so best not to ruminate too long), what if population growth plummets (remember population growth is one of the variables that has driven the value of the market up over time).

Ahhhhhh. This makes me want to stuff my cash in my mattress.

Bottom line, we can’t predict the future.

There’s always an element of risk when it comes to investing. This is true when you invest in the stock market, real estate or your friends tech start up. But, remember, there’s also room for great reward.

Ready to learn more? Be sure to check out these articles before you take off…

What is Financial Literacy?

Do you Have a Fear of Failure? How to Overcome Fear and Turn Failure into Success

References:

(1) Nickerson, R. S. (1998). Confirmation bias: A ubiquitous phenomenon in many guises. Review of general psychology, 2(2), 175.

Post Photo by Chris Liverani on Unsplash
Eggs in a basket Photo by Natalie Rhea Riggs on Unsplash
Banana Photo by Scott Webb on Unsplash