Understanding the Stock Market

Why People Invest

I already explained what a stock is, so I should have the foundation to go ahead and discuss what the stock market is in some detail.

Before I do that, I need to explain why we want to invest in the first place.  In the chart below you can see some different lines.  The ones to focus on for right now are the orange line, which is a representation of a dollar invested in the US stock market, and the light green line, which is a representation of a dollar invested in US treasury bills.  It is obvious that a dollar invested in the stock market will grow more than a dollar invested in a treasury bill, but why is that?  A treasury bill is issued by the US government and is what is referred to as a risk free investment because it is very unlikely that the US government will fail to pay someone holding a treasury bill.  Being invested in the stock market is riskier because you are owning pieces of companies which can go down in price, even go to zero if the company goes bankrupt.  Investors need to be compensated for taking risks when they are investing in companies, otherwise they would only invest in the treasury bills.

The difference in returns between the treasury bills line and the stock market line is called the market premium, or the amount of investment return over and above a risk free investment that can be expected for investing in stocks.  So when you are saving for a long-term goal, it can make sense to invest in stocks because they will give you a higher expected return over time.  The chart below shows the returns of the total US stock market minus the returns of US treasury bills every year from 1927-2012.  On average, the market premium was 8.05%.  This means that on average, being invested in stocks meant that you could expect a return 8.05% higher than the return from being invested in treasury bills.  Notice that the red bars are years where stocks had negative returns; that is the risk of being invested in stocks rather than treasury bills.


The Market

We know stocks are pieces of ownership of companies that allow individuals to partake in the company's growth and losses.  Partaking in the growth and losses of a company by buying an ownership stake is called investing in the company, and investors receive higher expected returns for being invested in companies because of the risk involved.  All of the investors that buy stocks need a place to buy and sell their stocks, and that is where the idea of the stock markets becomes important.  If there was not a stock market, people that wanted to buy and sell stocks would have to find each other manually; it would be like Craigslist for stocks.  Having consolidated public stock exchanges makes it much more certain that a stock will be available to buy when you want to buy, and you will be able to sell when you want to sell.  This makes stocks much more liquid, or much easier to convert back into money.  If stocks became illiquid they would go down in value drastically because people would not be able to convert their ownership in a company into money when they need to.  The integrity of the stock market is a very important part of investing, and there are safeguards built into public exchanges to ensure that the markets remain liquid.  So it's easy enough to understand that the stock market is just a big public marketplace where investors can buy and sell stocks, but what are people talking about when they say the market is up or down?  Or when they talk about beating the market?  There are different stock markets around the world, and within different markets there are different stock exchanges.  So what is the market that people talk about in the media?

To explain this further I need to explain what an index is.

How an Index Works

You might have heard about the S&P 500, or the S&P/TSX Composite.  These are indexes.  An index is a grouping of stocks that has been selected to represent a particular market.  The S&P 500 is one of the best known indexes in the world; it is 500 stocks that have been selected by Standard and Poor's (a financial research company) to represent the US stock market.  When you hear that the S&P 500 is up, it means that the overall value of all of the 500 stocks included in the index is up.  It is important to keep in mind that although the S&P 500 has been selected by the very smart people at Standard and Poor's to represent the US market, it only contains 500 of the largest, most well known companies that are traded on public exchanges in the US; overall, there are about 5000 companies with stock that trades on public exchanges in the US.  One of the major uses of an index like the S&P 500 is benchmarking.  Benchmarking is using the performance of an index as a tool to compare the performance of other groupings of stocks, or individual stocks.  When you invest in a mutual fund, or have a broker tell you that they will build you a portfolio that will beat the market, they are saying that they will pick a stock or a grouping of stocks that is different from their benchmark index that they think will allow your investment to perform better than investing in the companies in the index.  If a fund invests in American companies it will likely use the S&P 500 as a benchmark index, and a fund that invests in Canadian companies will likely use the S&P/TSX Composite as a benchmark index.  The whole idea here is that if someone has the ability to predict which companies within a market will perform well, they can buy those companies instead of buying the companies in the benchmark index so that their fund will perform better than the index.  Now, because there is a lot of research involved in deciding which stocks will do well and which ones will do poorly, there are fees that have to be paid to the investment manager if they are going to try and beat the market for you.

Investing in the Market

You can choose to invest in an index that has been built to represent a given market for a very minimal cost, or you can choose to pay a significant cost to invest in a fund that is going to try and do better than the index.  It is very easy to invest using both of these methods.  You can buy something called an Exchange Traded Fund (ETF) which will track an index, or an index mutual fund which will do the same.  Companies like Vanguard and iShares allow people to invest in an index of their choice for a very low cost; you can choose to invest in the S&P 500 which we know is 500 of the largest companies listed on US exchanges, or the Russell 3000 which is an index that is designed to represent all  of the companies in the US market, or the MSCI EAFE which represents all developed markets outside of the US and Canada, and the possibilities of indexes to invest in go on forever.  Investing in a fund that will try and beat the market is equally easy to do, companies like Fidelity have plenty of different funds with different strategies designed to outperform a given index.  To illustrate the difference in cost of these two strategies, the Vanguard Total Market Index which invests in 3000 American companies designed to represent the total US market costs you .05% of your investment account to hold, and the Fidelity US All Cap fund which is designed to "seek the best in US equity opportunities" costs you 2.4% of your investment account to hold.  Both of these funds allow you to invest in the American market, but one is designed to do whatever the market does, and the other is designed to beat the market.

Remember Efficient Markets?

I write about markets being efficient often.  Remember that if markets are efficient, all available information is included in the price of a stock.  With that in mind, let's look at the idea of trying to pick which stocks will be the best ones to invest in.  The people that are picking the stocks that will be included in a portfolio that is trying to beat the market are using massive amounts of information to make their investment decisions.  These people will know everything that there is to know about a stock before they select a company to invest in.  But think about all information.  That's a lot of information, and there's new information coming out all of the time.  Even if an analyst does know everything about a stock before they buy it, it is impossible to predict all new information, and all new information will be included in the price of the stock as soon as it becomes available to the public.  So, we should try and get information about stocks before the information is public? No.  That is insider trading which is illegal.  Point is, all information is included in the price of a stock, and new information is random, so stock prices are random.  Still want to try and pick the stocks that are going to beat the market?  Good luck.  My opinion is that if you can't beat them, join them.  Indexes are beautiful tools that should be taken advantage of when constructing a portfolio.  Which indexes?  That will have to be another day's post.