Why Does The Stock Market Go Up?: Everything You Should Have Been Taught About Investing In School, But Weren't

by Brian Feroldi

And yet, during those decades of learning, I’ve never come across a book that did a great job of answering the most important question that I had about the stock market: Why does the stock market go up? You can’t invest with confidence if you don’t know the answer to that question.

If

you don’t understand why the stock market goes up, then you won’t know why it crashes sometimes or wh...

Let me repeat that: The stock market is the greatest wealth creation machine of all time.

The stock market can allow anyone to turn small amounts of money into life-changing wealth over time.

The total number of shares that a corporation has outstanding is a completely arbitrary number. It can also be changed at any time. The number of shares outstanding and the price of a single share do not tell you anything about the size or importance of a business.

time over every 20-year holding period.

stock market crashes are nothing new. They are a normal part of investing. Since they are always caused by human emotions, they are also unpredictable. History shows that the stock market crashes every decade or so. The odds are good that it will continue to crash every decade or so into the future.

The stock market works in a similar way. It has always recovered from past downturns and emerged stronger on the other side. Here are three big reasons why: First, tough times force companies, workers, and entrepreneurs to try new things. They abandon old business practices and adopt new ones. They begin to experiment with new technologies. Consider what happened in 1873. The U.S. was in a depression. Yet

in the following decade new innovations like the phonograph, light bulb, subway system, and telephone were all invented. Or consider the Great Depression.

The 1930s were one of the toughest economic periods in American history. Yet economic historian Alexander Field called it the most “technologically progressive decade of the 20th century.” In 2020, the COVID-19 pandemic caused millions of businesses to shut down. Video conferencing, work from home, and e-commerce b...

survived, but they set themselves up for long-term success. When tough times hit, businesses are forced to innovate and try new things. That innovation leads to new ...

Second, weak businesses go belly-up in tough times, but strong businesses survive. The strong businesses eventually capture the customers of businesses that failed. That allows them to emerge stronger than ever before. Third, the government steps in to provide assista...

There are several forces that work together to drive earnings up over time. Those forces are: 1.Inflation 2.Productivity 3.Innovation 4.International expansion 5.Population growth 6.Acquisitions

As long as all of these forces remain in place, it is a near certainty that profits will continue to rise over time.

There have been ups and downs, but the long term trend is clear: productivity consistently goes up. That’s wonderful news for humanity. Improved productivity allows businesses to produce goods and services more efficiently. This can allow them to either increase their margins or pass on their savings to consumers.

A stock buyback is when a company repurchases shares of its stock from its investors.

This reduces the total number of shares outstanding. In turn, the earnings per share increases because the total number of shares go down.

In any given year, stock buybacks don’t amount to much. They grow earnings by 1% or so. However, when added up over time,

they consistently lead to growth in earnings on a...

Exchange-traded funds and index funds usually have much lower expense ratios than mutual funds.

Some index funds have no expense ratio, so you can literally invest for free! The good news is the cost to invest has fallen dramatically over the last few decades.

Misaligned Incentives: Most mutual funds earn money based on the total dollar amount of the assets that they manage, not based on the performance of the fund. A mutual fund with $1 billion in assets will make 100 times more revenue than a fund with $10 million to assets, regardless of how the fund performs. For this reason, mutual fund managers spend a lot of their time convincing investors to give them money instead of focusing on the best investment strategy. Career Risk: To outperform the market, a mutual fund manager needs to be willing to invest in novel ways. However, when you invest differently than other investors, you run the risk of underperforming for long periods of time. If a manager performs poorly while investing unconventionally, they have a harder time justifying their actions. That increases their risk of being fired.

This ‘career risk’ encourages mutual fund managers to invest conventionally, which makes it much harder to outperform the market.

Fees: Many mutual funds are actively managed, which means that a human makes all of the investment decisions. Mutual fund managers are well compensated, so the fund has to charge extra to pay their salary. The average mutual fund had an expense ratio of 0.66% in 2019, which is much higher than the 0.13% that was cha...

Forced Short-Term Focus: Many investors judge th...

their funds over short periods of time (a year or less). If the mutual fund performs poorly during that time, then some investors will withdraw their money. When that happens, the mutual fund manager is forced ...

The exact opposite occurs when a fund does well. Investors add money to the fund, which forces the manager to buy stocks at higher prices, even if they don’t want to. These actions force fund managers to invest for th...

Forced Diversification: Diversified mutual funds are not allowed to invest more than 5% of their fund in any single stock. If a mutual fund manager loves a business but it reaches 5% of the fund, they are forced to trim it and invest elsewhere, even if they don’t want to. Size: Mutual funds that are successful attract lots of money. As a fund grows, the manager has to make bigger investments. As a fund becomes larger it can influence market prices wh...

When these factors are combined, it’s understandable why most mutual funds underperform the market. It’s not because mutual fund managers aren’t smart; the way that mutual funds are structured makes

it

hard for them to outperform index funds. For that reason, index funds are the best c...

It’s worth mentioning that this isn’t an all-or-nothing question. Lots of investors (myself included) split their investment dollars between index funds and individual stocks.

It’s never been easier to be your own financial advisor than it is today.

Here are some ways in which a financial advisor can add a lot of value: ■Help you deal with information overload ■Organize your financial life ■Provide a second opinion on an investment ■Prevent you from making an emotional financial decision

Help you create an investment plan ■Connect you with other financial professionals that specialize in taxes, insurance, estate planning, and more ■Keep the big picture in mind ■Run different scenarios to help you make better decisions ■Give you peace of mind ■Help you determine if you’re on track to accomplish your goals ■Help you make big life decisions

Make retirement decisions related to Social Security, Medicare, and ...

They can be expensive depending on their fee structure ■Many financial advisors are not fiduciaries, which means they are not legally obligated to put their client’s interests ahead of their own ■Many financial advisors are actually just salespeople Whether or not you should hire one all boils down to this question: Are you ready, willing, and able to spend time learning how to become your own financial advisor?

If the answer is yes, you might not need to hire a financial advisor. If the answer is no, hiring a financial advisor makes sense.

The good news is that this isn’t an all-or-nothing decision. You can handle most of your financial life yourself and hire a financial advisor whenever you feel like you need help...

And yet, the best time to invest is when the economy is doing terribly. That’s worth repeating. The best time to invest is when the economy is doing terribly. Don’t believe me? The returns from the S&P 500 are highest when the unemployment rate is above 9%.

The returns from the S&P 500 are lowest when the unemployment rate is under 5%.

When you are looking backwards at the history of the stock market, timing the market seems incredibly easy. When you are trying to do it in real-time, it’s incredibly difficult. The good news is that there’s no need to time the market. If you invest on a regular schedule and hold for the long-term, the odds are extremely high that you will do great.

A stock split is when a company divides existing shares of its stock into multiple new shares of stock in order to lower the price.

Stock splits confuse a lot of people. Here’s an easy way to think about it: you buy a large cheese pizza that is cut into 4 equal slices. However, you wanted 8 slices. What do you do? You cut each slice in half. Voila! You now have 8 slices.

Stock splits can be confusing, largely because the price of a stock is easy to look up, but the total value of the company isn’t as easy to find.

The key point to remember is this: stock splits do not create any value for investors. They only increase the total