How does the stock market work?

The fastest way to lose half of your money is not a stock market crash but a divorce, separation or a poor business decision (so it’s a good idea to make sure you’re on the same page with your partner when it comes to joint finances.)

Many have felt disheartened by the stock market in recent times, especially with the historic GameStop trading fiasco. It’s easy to feel confused and assume the market is rigged against the smaller investors.

However, the small-time investor could have a ton of advantages over the pros. They don’t need to pay attention to short-term performance or benchmarks or made-up risk-adjusted return metrics. They can play the long game and not worry about all the stuff professional investors are forced to obsess over.

In Ben Carlson’s book, Everything You Need To Know About Saving For Retirement, he talks about how the stock market works. This is an edited extract from chapter eight.

**********

After getting engaged my wife and I began having some deeper philosophical conversations about how we would run our joint finances. We were in our mid-to-late 20s at the time so I informed her I would like to put the majority of our retirement savings into the stock market.

My wife, like most normal people, did not know much about the stock market except for what she heard on the news or saw on TV and in the movies. She did not give much thought to investing in stocks. So when I told her we would be saving the bulk of our retirement money in stocks (especially when we were younger) she was initially concerned.

What follows is more or less what I told her (and despite going through this exercise she still agreed to marry me if you can believe it).

The stock market is the only place where anyone can invest in human ingenuity. It is a bet on the future being better than today. Stocks can be thought of as a way to ride the coattails of intelligent people and businesses as they continue to innovate and grow. Short of owning your own business, buying shares in the stock market is the simplest way to own a slice of the business world.

The greatest part about owning shares in the stock market is you can earn money by doing nothing more than holding onto them. When companies pay out dividends to shareholders, you get cold hard cash sent to your brokerage or retirement account which you can choose to either reinvest or spend as you please.

Many people compare the stock market to a casino but in a casino the odds are stacked against you. The longer you play in a casino, the greater the odds you’ll walk away a loser because the house wins based on pure probability. It’s just the opposite in the stock market.

The longer your time horizon, historically, the better your odds are at seeing positive outcomes. Now these positive outcomes don’t guarantee a specific rate of return, even over longer time frames. If the stock market were consistent in the returns it spits out, there would be no risk.

If there were no risk, there would be no wonderful long term returns. And because there is risk involved when owning stocks, your returns can vary widely depending on when you invest in the stock market.

It has been possible to lose money over decade-long periods in the past. Even 20 to 30 year results can see a big spread between the best and worst outcomes. However, it is worth noting that even the worst annual returns over 30 years in the history of the U.S. stock market would have produced a total return of more than 850%. This is the beauty of compounding. The worst 30 year return for the S&P 500 gave you more than 8x your initial investment.

$10,000 dollars invested in the S&P 500 in the year:

  • 2010 would be worth $37,600 by September 2020
  • 2000 would be worth $34,200 by September 2020
  • 1990 would be worth $182,300 by September 2020
  • 1980 would be worth $918,500 by September 2020
  • 1970 would be worth $1,623,500 by September 2020
  • 1960 would be worth $3,445,000 by September 2020

I’m ignoring the effects of fees, taxes, trading costs, etc. here but the point remains that over the long haul, the stock market is unrivaled when it comes to growing money. And the longer you’re in it the better your chances of compounding.

Having said all of that, there is an unfortunate side-effect of this long term compounding machine. Stocks can rip your heart out over the short term. If there is an ironclad rule in the world of investing, it’s that risk and reward are always and forever attached at the hip. You can’t expect to earn outsized gains if you don’t expose yourself to the possibility of outsized losses. The reason that stocks earn higher returns than bonds or cash over time is because there will be periods of excruciating losses.

The stock market is fueled by differences in opinions, goals, time horizons and personalities over the short term and fundamentals over the long term. At times this means stocks overshoot to the upside and go higher than fundamentals would dictate. Other times stocks overshoot to the downside and go lower than fundamentals would dictate. The biggest reason for this is because people can lose their minds when they come together as a group. As long as markets are made up of human decisions it will always be like this. Think about how crazy fans can get when their team wins, loses or gets screwed over by the refs. These same emotions are at work when money is involved.

How you feel about investing in the stock market should have more to do with your place in the investor’s lifecycle than your feelings about volatility.

**********

Remember, the stock market isn’t the only way to invest money, but it helps us with portfolio diversification, a well-practised strategy for protecting our future wealth.

Scroll to top

Bringing the human side to financial planning.