The stock market is risky!

The_Cardsharps

Clearly the only difference between this and the stock market is the feathered hat.

You’ve probably heard this from a dozen different people in your life.  That’s because its extremely true.  If you needed a way to legitimately lose your life savings in a couple days I have some bulletproof stock market strategies to recommend.  The stock market is like a car, it is extremely dangerous in the hands of someone who has no idea what they’re doing, and even if you do everything right something bad can still happen and wreck your life.  However, sometimes it is the only practical way to get from A to B, and after you understand what you’re doing it can substantially improve your life for the better, and its risks can be mitigated.  Generally, folks are unfamiliar with how the stock market works, and understandably nervous about the concept.

The concept of a “stock” is probably an over-broad term as it is.  People regularly categorize some of their investments as “stocks”.  When budgeting for spending however, no one budgets a certain amount of money for “services” and a certain amount of money for “goods”.  If the discussion on personal finance never got more specific than making sure that your spending allocation was your age in percentage for services and the rest on goods, I’d probably go crazy, yet people routinely recommend the same sort of breakdown for investments.  A stock is a pro-rata ownership of a company.

In the US companies can own all kinds of things.  Let’s take two companies that everyone is familiar with as an example, Facebook, and McDonald’s.  If you told someone that you own a website that makes money from ad sales as well as the employment contracts of some of the smartest people in the world they would realize that it is very different from owning some of the best real estate in the world along with franchise agreements for a burger chain.  It’s obvious in this case that owning each of these things are very different propositions, for some reason when you call them both stocks, the nuance goes out the window and all people seem to care about is that they, as Will Roger’s put it: buy some good stock, and hold it till it goes up, then sell it. If it don’t go up, don’t buy it. If you own a stock, you are part owner the underlying business.  This is what separates the stock market from gambling, the owner of a stock makes money from the profits of the underlying business, and could make money even if there was no one else trading stocks.  The gambler makes money only from other gamblers.

Are stocks gambling?

People like to equate any risk with gambling.  They love to compare the stock market to a casino.  It’s fun to compare these rich Wall Street folks with gamblers.  There is one important difference, gambling is a zero-sum game.  Stock ownership is a positive-sum.  What’s the difference?  In any gambling, for each dollar won there is a corresponding dollar lost.  If you and I play poker, one of us ends the night with less money and one ends with more.  We can’t both show up with $100 and both walk away with $400. that’s because when gambling you make money from other gamblers, therefore in aggregate gamblers make no money.  Investors, on the contrary, make money in aggregate.  The average dollar invested in the stock market earns about 10% annually.

But, but I read this book and there’s all of this fast trading…and I’m getting cheated!

Yes, there are people doing some suspicious things on the stock market, but is it going to make any difference in your returns?  Not unless you trade in huge blocks of millions of dollars worth of stocks.  The effect high frequency traders will tend to have on you is make your trades a couple tenths of a penny cheaper (Yay?).  Let’s play with the idea a little though.

Trade less, own more

The real likely situation isn’t that you’re going to lose money to people “cheating”, but simply because you have no idea what you are doing, however, the only time someone else can get the better of you in the stock market is when you buy or sell a stock.  This is also when you encounter mosts costs involved with the stock market.  The broker charges you a fee, you have to pay some portion of the bid-ask spread, and you might trigger taxes.  The average company in the United States makes money or expects to make money in the future, that is, after all, why they exist in the first place.   Whenever you trade a stock you cost yourself some of the profits from the underlying business that the stock represents.  Some of that might be from taxes, some because you’re selling too cheaply or buying too dear and the guy on the other end of the trade knows more than you.  The optimal solution if you don’t think you’re the smartest guy in the stock market (you aren’t) is to buy a stock and only sell it years and years later if you need the money.

Diversify

All businesses are exposed to some kind of risk, so don’t buy just one stock, you should probably buy a bunch of different stocks.  Make sure that the businesses that you own are exposed to different risks.  It might make sense to own some of Apple, some Proctor and Gamble, some Exxon-Mobil, and some McDonalds.  Generally the benefits of diversification tend to trail off after the first 25 stocks or so.

How not to gamble

This has left us with a couple simple rules that we could use to construct a portfolio.

  • Pick 25 companies from a list of companies that you can buy on the stock market.  (Maybe from this list)
  • Make sure that they are in different industries, sell to different geographic areas, etc.
  • Buy them every month with your investible savings.
  • Don’t sell them.

If you follow these four rules I’d happily bet that you’d end up richer in ten years.

 

 

Disease Called Debt