You may have wondered ‘what is the stock market’ and second to this, ‘how can you make money from it’. This article will explain how it’s simpler than you might think.
Mainstream media often distort the answer to this question. We are all too familiar with the spectacles of wall-street and the images of trader meltdowns. If you are a millennial, you’ll be sceptical about the stock market. You will have grown up seeing the the fall of the Lehman Brothers, the 2008 financial crisis. Now your seeing the surge of House Prices Bitcoin, you might feel like you are watching it all over again.
Those who do want to get a taste for the stock market are lead to believe you need to know how to pick stocks. There are many common myths around the stock market. You might believe that you have to know about stocks to make money in the stock market. You might also think that you need to spend all your time buying and selling to keep pace.
There Are Many Myths Surrounding The Stock Market
In the past, when I have been asked ‘what is the stock market ‘and ‘how do you invest’? People are often surprised at just how simple investing actually is. The breaking down of this barrier is the largest step towards wealth creation.
You need to dispel the myths and legends people create around the stock market. This is the first step towards a journey to financial freedom and independence. The problem is that many people dismiss the idea of being able to actually make money in the stock market. They call it a pipe dream.
In reality, the stock market is not a place to get rich quick (although it can be) or for gambling with you money. It doesn’t have to be a full-time occupation (e.g. day trader). It can be responsible place to accumulate wealth and maintain a passive income. Once it’s set up you can switch off and forget about it.
Disclaimer: This article should not be considered as financial advice. You are responsible for your own financial research and decisions. When investing capital is at risk.
Andrew| Mr Money Side Up
What Is The Stock Market & How Does It Work?
Stocks or shares of a company represent ownership of equity in a company. The price of a share can either grow or decline in value based on a company’s financial or strategic performance, or macroeconomic factors. Speculation can also drive prices up or down.
The stock market is an online marketplace that contains public companies that you can buy shares in. Every day, there are millions of transactions relating to stocks. People can buy and sell them, and their value can change over time, as can the dividends they produce. The stock market is therefore the sum of all these individual moving parts.
Most countries have one or more stock marketplaces such as the New York Stock Exchange or The London Stock Exchange. All of these stock exchanges form the entirety of the stock market in their individual countries and globally.
Stock Market Indices
Most countries have a number of stock market indices. These rank and structure hundreds or thousands of individual companies. Each is ranked and categorised by their market capitalization. Here are some example indices by country:
- United Kingdom: FTSE 100
- France: CAX 40
- Italy: FTSE MIB
- Germany: DAX 30
- Spain: IBEX 35
- United States: S&P 500
As the performance of its constituent parts rises or falls this will drive up the valuation of the index and this is how we see how the stock market is performing as a whole. If a business performs strongly it will rise up the index, and potentially be promoted to a superior index (e.g. FTSE 250 to FTSE 100) or vice versa if it performs badly.
How Can You Invest In The Stock Market?
There are various ways you can invest in the stock market such as an ETF (exchange traded fund). At a very simple level you can invest into a fund which tracks a stock market index or even multiple indices, depending on how much you want to diversify. This is referred to as Index Investing.
Essentially every time you invest into your ETF fund this equates to buying ownership of hundreds or even thousands of businesses. It’s important to understand this only in the sense that you are aware that when you are investing in a fund you are buying a little piece of the stock market.
Each fund has a portfolio value and unit price which is calculated using the values of the stocks and indices contained within it. Using this approach you can simply track the performance of the stock market rather than trying to pick stocks.
As we mentioned above, companies can rise and fall through the indices, so by tracking the indices rather than picking a selection of companies you don’t have to worry about individual business performance.
You can invest in a wide variety of investment vehicles such as securities, bonds and commodities. You can also diversify by focusing on the size of companies; large, medium and small cap. Which can be used to manage your stock allocation and either reduce or increase the volatility in exchange for potential returns. For the purpose of this post I will continue to focus on a simple large cap stock allocation.
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What Is The Stock Market’s Average Rate Of Return?
Investing in a responsible way gives you a high potential rate of return on your money. In other words – it lets you grow your money over a number of years. It is one of the most consistent investment vehicles over the long-term, especially when compared to other forms of investment.
If I invested £10,000 now, then there is a strong likelihood (based on historical data), that it would reach a value of over £75,000 in 30 years time. This would require an average annual return rate of 7% and you would need to leave this untouched for the entire period (although you could withdraw it if you wanted to).
This return rate of 7% (after inflation) might seem far fetched, especially when you consider it to the measly interest rates on savings accounts. When you consider all the economic and political crises over the last few decades and even the last century you might be reluctant to believe me.
However, this simply adds volatility into the mix and whilst one year the stock market might trade down -20% one year, it might then trade up 11% for the next 7 years. Averaging out a solid positive return. This volatility is simply the ticket of your admission to stronger returns than can be offered by bonds or cash.
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Take the last 5 years of the S&P 500 as an example. The annual percentage change has been as follows:
- 2019: 28.88%
- 2018: -(6.24%)
- 2017: 19.42%
- 2016: 9.54%
- 2015: -(0.74%)
- 2014: 11.39%
4. Why You Shouldn’t Try To Outperform The Market
The percentage of the population that can outperform the market is about 1%. You are talking about unique individuals like Warren Buffett who have managed to do this. I’ve lost count of the stories of frustration I’ve read when people try to pick stocks.
Fund managers may claim to be able to beat the market with complex strategies but their returns often fall below the performance of the market. With 92% of actively managed funds lagging behind the index in performance over a 15 year period.
However, any positive performances attributed to the fund manager, in reality, is only because they were riding on the tails of the market. Merged or liquidated funds are also represented and therefore push to average performance above the benchmark (see survivorship bias). Therefore actively managed fund performance is likely to be worse.
Whilst fund managers say that index investing will only give you average returns (because it only tracks the market) by going for average, you actually achieve above-average returns. This is because most fund managers underperform against the market.
A Simple But Effective Approach To Investing
It might seem obvious that if you only buy the top players and ignore the dogs of the market you might outperform the market. However, you never know which businesses will fall from grace, or be the next turnaround success.
Therefore approach your fund selection with a cost-focused approach and try to resist being upsold to funds that suggest you will get better returns. This is simply a lie because nobody can predict what the market will do next, even if they say they can.
When people ask, what is the stock market and how can I make money with it, they are often convinced that investing requires complex strategies and lots of knowledge and time. In reality, the simpler the strategy the better your chances of a solid return are.
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