Have you ever wondered WTF the stock market is and how it works? Well, look no further. Today we’re breaking it down so you can finally understand just how the stock market works.
When I thought about investing just a few years ago, it’s like my brain would shut off.
That’s too hard. Too complicated for me. Not something I could possibly understand.
But the more and more I learned about building wealth, the more I realized– I needed to invest if I ever wanted to stop working someday.
For a really long time, I was delusional.
And it’s a delusion many of us have.
I thought I could save my way to wealth.
Like I literally thought I would just hoard my money in a bank account, cross my fingers, and hope it would somehow be enough.
It sounds silly now, but I was truly THAT intimidated by the stock market. So much so, that I thought burying my head in the sand was an appropriate response.
But here’s the thing…
You cannot save your way to wealth.
Read that again.
You CANNOT, unless you make OODLES of money, save your way to wealth.
Think about it this way.
If you saved $1k a month in a high-yield savings account for 40 years, with a 0.5% average annual return, in 40 years you’d have $531k saved.
If you INVESTED $1k a month in the S&P 500 which has averaged about 10% returns for the last 50+ years… you could have $5.36 million in 40 years.
Big difference, huh?
And that’s doing the same amount of work.
In both scenarios we’re using $1k.. But in the scenario of investing? Our money is working a LOT harder for us.
Okay... but what IS investing in the stock market?
Now, before we dive into how the stock market works, let’s get some basics down.
What even IS investing in the stock market????
It all begins with something called a stock.
Let’s say you decide one day you want to grow you money, and you want to do that by buying a part of a company– let’s say Apple in this example. To buy a share of Apple, you have to go to the store where you can buy companies– aka, the stock market.
So, feeling empowered you take your $20, and you buy a share of Apple’s stock.
Wahoo!! You are now an investor and a part owner of Apple! Pretty dang cool, huh?
By owning a part of this company, you benefit when Apple’s stock price goes up, and you also deal with the pain when the stock price goes down.
This is investing.
Now here’s the cool thing about investing– if you do it correctly, it can grow your money… without you having to do anything.
The Almighty Power of Compound Interest
Let’s say you put in $20 and just let it grow for 30 years, never adding in another dollar. The math of this looks something like this:
(Keep in mind this is a completely fictional scenario and not a representation of real returns. We’re making numbers up here to illustrate how investing in the stock market works.)
10% of $20 is $2, so you earned $2.
We don’t take that money out– we let it grow. So when you earn 10% again, then instead of your $20 earning 10%, you actually have $22 earning 10%.
And 10% of $22? It’s $2.20. Wohoo!!! So now you have $24.20 invested instead of just $20, and you only put in $20! YAY!
On and on we go, and by year 30, you have a whole $350 invested, even though you only put in $20.
But what if we invest more??
Now, I know those numbers aren’t exciting right– so what if you put in say $200 a month for 30 years instead?
Assuming an average annual return of 10%, you’d have nearly $400k despite only putting in $72,000 of your own money.
Not bad, eh?
Why Folks Lose Money in the Stock Market
Now, if you’re anything like me… when I was starting to learn about investing I was TERRIFIED of it, because I believed that I would lose money in the stock market. I thought the stock market was basically gambling because in my mind the folks who were earning money in the stock market were trading individual stocks, and “betting” on the next best company.
Turns out there’s a better way to do things.
The Old Way of Investing in the Stock Market
The old way to invest?
Buying low and selling high.
What’s the issue with this?
Well, this is something called timing the market. This means you spend time watching a stock price to see when the best time to buy is (when it’s low) and when the best time to sell is (when it’s high).
Sounds logical, right? So what’s the issue?
Even though this sounds really simple, it’s actually incredibly difficult to do this and even the greatest minds in finance fail to do this consistently over the long term.
Dow Jones - DJIA- 100 Year Historical Chart
Above is a graphic of the Dow Jones index over the last 100 years. The Dow Jones contains about 30 different blue chip stocks inside of it (blue chip is just a fancy word for solid companies with solid returns over a long period of time). The Dow Jones was designed to be an indicator of how the overall US stock market is doing, with just 30 stocks.
What do you notice about the chart? A lot of ups and downs right? But overall, we’re heading in the right direction… up.
Now here’s why trying to time the ups and the downs is SO difficult.
So many different things impact the performance of the stock market.
Things that Impact the Performance of the Stock Market
Prolonged rising prices
- Elon Musk
And so much more!
Notice– out of all of those things, we control so little– just our emotions and panic.
And there are more costs to trying to time the market.
Why Timing the Market is a Losing Battle
Trying to time the market means you could be missing out on some of the best days of market performance. There have been multiple studies to show this, including a study done by JP Morgan that showed that if you missed the top 10 best days in the stock market from 2002 to 2022?
Your overall return was cut in almost half from 9.40% to 5.21%.
My favorite pseudo study was actually a bet by Warren Buffet.
Warren Buffet did an infamous bet to see if hedge fund managers, whose job is to beat the market, could do better than the S&P 500 index fund over 10 years, which is essentially buying 500 of the largest stocks in the US and holding them through these ten years. You’re not buying or selling, you’re just holding on.
Guess what happened?
The S&P 500 index fund made 7.1% on average per year and the hedge fund made 2.2%.
That’s a potentially MASSIVE difference over the long term.
Think about it this way– if you had invested $10k at the beginning of the experiment, the buy and hold investor would have nearly $20k, while the hedge fund would’ve grown their $10k to $12.4k.
What We Do Instead: Get Lazy
Now, I’m sure you’re wondering… what do we do instead???
We get lazy.
As lazy investors– we buy and we hold low-cost diversified investments for the long term.
No timing the market. No trying to figure out the best time to get in and out. Instead– we invest, and we chill.