The stock market can be an intimidating place: it’s real money on the line, there’s an overwhelming amount of information to follow, and people have lost fortunes in it very quickly.
But it’s also a place where thoughtful investors have long accumulated a lot of wealth.
The primary difference between positive and negative outcomes is related to misconceptions about the stock market that can lead people to make poor investment decisions.
With that in mind, I present to you ten truths about the stock market.¹
There’s nothing the stock market hasn’t overcome.
“Over the long term, the stock market news will be good,” billionaire investor Warren Buffett, the greatest investor in history, wrote in an op-ed for The New York Times during the depths of the global financial crisis. “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Warren Buffett, chairman and CEO of Berkshire Hathaway, in an interview with Squawk Box on February 29, 2016. (Photo by: Lacy O’Toole/CNBC/NBCU Photo Bank/NBCUniversal via Getty Images) ·CNBC via Getty Images
Since that op-ed was published, the market emerged from the global financial crisis. It also overcame a U.S. credit rating downgrade and a global pandemic among many other challenges. The Dow closed Thursday at 34,912, just 2% from its all-time high.
Btw, historically you didn’t have to wait a hundred years for positive returns. Since 1926, there’s never been a 20-year period where the stock market didn’t generate a positive return.
The chart below from JP Morgan Asset Management does a nice job illustrating this. The grey bars represent each calendar year’s return and the red dots represent the intra-year drawdowns.
The stock market typically sees large drawdowns every year. (Source: JPMorgan Asset Management)
Bear markets are no picnic either: They can happen quickly, like the S&P500’s 34% drop from February 19, 2020 to March 23, 2020; and they can happen painfully slowly, like the 57% decline from October 9, 2007 to March 9, 2009.
Investing for long-term returns means being able to stomach a lot of intermediate volatility.
Check out the chart below from Ritholtz Wealth Management’s Ben Carlson. It plots the S&P 500’s annual returns since 1926. If 10%-ish returns were commonplace, you’d see a tight horizontal line of dots just above the x-axis.
(Source: Ben Carlson, A Wealth Of Common Sense)
This chaotic mess of dots illustrates just how difficult it is to predict what next year’s returns are going to be. This holds true even if you know exactly what’s going to happen in the economy. Outside of the Great Depression and the Global Financial Crisis, it’s difficult to make out history’s major economic booms and bust.
The good news is most of the dots are above the black line. Indeed, stocks usually go up.
A stock can only go down by 100%, but there’s no limit to how many times that value can multiply going up.
Yes, we’ve seen some pretty bad sell-offs in the stock market. But it’s gone up manyfold more. It’s not guaranteed, but it’s offered. From its low of 666 in March 2009, the S&P 500 is up more than 6x today.
Any long term move in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings.
News about the economy or policy moves markets to the degree they are expected to impact earnings. Earnings (a.k.a. profits) are why you invest in companies.
There are many valuation methods that’ll help you estimate whether a stock or stock market is cheap or expensive. We won’t go through all of those here.
While valuation methods may tell you something about long-term returns, most tell you almost nothing about where prices are headed in the next 12 months. Over short periods like this, expensive things can get more expensive and cheap things can get cheaper.
It’s worth noting that prices can be cheap or expensive for extended periods of time. In fact, some folks would argue valuations are not mean-reverting.
Investing in stocks is risky, which is why the returns are relatively high.
Even in the most favorable market conditions, there will always be something keeping the most risk-averse folks on the sidelines. For more, check out Yahoo Finance Morning Brief’s chart of the decade.
Surveys of market participants will yield lists of top risks, and ironically the most commonly cited risks are the ones that are already priced into the markets.
It’s the risks no one is talking about or few are concerned about that’ll rock markets when they come to surface.
While the U.S. stock market’s performance is closely tied to the trajectory of the U.S. economy, they’re not the same thing.
The economy reflects all of the business being conducted in the U.S. while the market reflects the performance of the biggest companies — which typically have access to lower-cost financing and have the scale to source goods and labor more cheaply.
We could very well be on the brink of a dreadful, multi-year long bear market. Who knows?
However, the stock market has an upward bias.
This makes sense if you think about it. There are way more people who want things to be better, not worse. And that demand incentivizes entrepreneurs and businesses to develop better goods and services.
And the winners in this process get bigger as revenue grows. Some even get big enough to get listed in the stock market. As revenue grows, so do earnings.
¹ The “stock market” is a general term usually used to refer to the major U.S. indices: the Dow Jones Industrial Index, the S&P 500, and the Nasdaq. When I refer to “stocks,” I’m usually referring to the S&P 500. When discussing specific stats, I’ll be explicit about what I’m talking about.
