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TME 023: The Stock Market

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What is the Stock Market?

The stock market is a market where shares of public companies are issued and traded. The companies are traded either through exchanges or over the counter markets. The stock market is also known as the equity market. Many time people complain about the stock market but the stock market is one of the most important components of a free market economy. The stock market provides companies with easy access to capital in exchange for giving investors ownership in the company. For the investor the stock market makes it possible to grow small sums of money into large ones. The stock market lets investors in companies participate in gains or losses of the companies whose shares they hold.

When a company makes money then an investor in that company makes money through dividends or by selling the appreciated stock.   The downside is that when a companies stock loses value then the investor will lose money.

The stock market can be split into two main sections: the primary market and the secondary market. The primary market is where new issues are first sold through initial public offerings. Institutional investors typically purchase most of these shares from investment banks. All subsequent trading goes on in the secondary market where participants include both institutional and individual investors.

Stocks are traded through exchanges. The two biggest stock exchanges in the United States are the New York Stock Exchange, founded in 1792, and the Nasdaq, founded in 1971. Today, most stock market trades are executed electronically, and even the stocks themselves are almost always held in electronic form, not as physical certificates.

If you want to know how the stock market is performing, you can consult an index of stocks for the whole market or for a segment of the market. Examples include the Dow Jones Industrial Average, Nasdaq index, Russell 2000, Standard and Poor’s 500, and Morgan Stanley Europe, Australasia and Far East index.

The stock market is one of the most important ways for companies to raise money. This allows businesses to be publicly traded, and raise additional financial capital for expansion by selling shares of ownership of the company in a public market.

The volume traded that an exchange affords the investors enables their holders to quickly and easily sell securities. This is an attractive feature of investing in stocks, compared to other less liquid investments such as property and other immoveable assets.

If you go out and invest in a piece of real estate you have to buy the place, which may take months. When you get ready to sell the property it may also take months to sell.

With stock you can buy and sell within minutes.

 

History has shown that the price of stocks and other assets is an important part of the dynamics of economic activity, and can influence or be an indicator of social mood. An economy where the stock market is on the rise is considered to be an up-and-coming economy. In fact, the stock market is often considered the primary indicator of a country’s economic strength and development.

Rising share prices, for instance, tend to be associated with increased business investment and vice versa. Share prices also affect the wealth of households and their consumption. Therefore, central banks tend to keep an eye on the control and behavior of the stock market and, in general, on the smooth operation of financial system functions.

Exchanges also act as the clearinghouse for each transaction, meaning that they collect and deliver the shares, and guarantee payment to the seller of a security. This eliminates the risk to an individual buyer or seller that the counterpart could default on the transaction.

The smooth functioning of all these activities facilitates economic growth in that lower cost and enterprise risks promote the production of goods and services as well as possibly employment. In this way the financial system is assumed to contribute to increased prosperity, although some controversy exists as to whether the optimal financial system is bank-based or market-based.

Recent events such as the Global Financial Crisis have prompted a heightened degree of scrutiny of the impact of the structure of stock markets, in particular to the stability of the financial system and the transmission of systemic risk.

 

Statistics show that in recent decades, shares have made up an increasingly large proportion of households’ financial assets in many countries. In the 1970s, in Sweden, deposit accounts and other very liquid assets with little risk made up almost 60 percent of households’ financial wealth, compared to less than 20 percent in the 2000s. The major part of this adjustment is that financial portfolios have gone directly to shares but a good deal now takes the form of various kinds of institutional investment for groups of individuals, e.g., pension funds, mutual funds, hedge funds, insurance investment of premiums, etc.

The trend towards forms of saving with a higher risk has been accentuated by new rules for most funds and insurance, permitting a higher proportion of shares to bonds. Similar tendencies are to be found in other industrialized countries. In all developed economic systems, such as the European Union, the United States, Japan and other developed nations, the trend has been the same: saving has moved away from traditional (government insured) “bank deposits to more risky securities of one sort or another”.

 

 The 100 Year Stock Market

It has been said that the stock market averages 12% per year over the last 100 years.

In the bible there was a man named Noah. He built a boat that was truly unsinkable because God was its captain. Now it was 120 years from the time God gave Noah a countdown to the flood until the flood came. Noah was about 480 years old at that time. It probably wouldn’t have been a bad idea for Noah to buy a mutual fund and sit on it for 3 or 4 hundred years. He could have been a wealthy man off his investments.

For us the story is a little different. We don’t have as much time as Noah had. You hear people say all the time the stock market averages 12% for the last 100 years.

Well who has 100 years and what is in the 100 years? It’s important to break the stock market into our time frame. We have 30 to 40 years max.

From 1929 peak to 1958 peak was 29 years. The Dow Jones Industrial average was 0% gain over that time period. That means if you put in $10,000 at the peak in 1929 by 1958 you money would be worth $10,000. The whole working life of a person the average was 0%. I realized that I cherry picked those years but lets look at another set.  If you bought at the bottom in 1932 and sold at the peak in 1966 you would have made a whopping 6.5% per year average.

Modern Time

I realize that I have used ancient data. That is 40 years ago. Use something more modern. If you invested $15484 in December of 1999 by November of 2013 your money would be worth $15644. That is well below the 12% average.

I realize that I could go back and from 1982 to today the market averaged 14.3% for that time frame. The question is will the market do that in your lifetime. Will it continue to move at a 14% trajectory? No one knows.

The Lesson

We don’t have 100 years. The long term buy and hold investor needs to break down the market into a series of thirty years. Are you satisfied with those numbers? You don’t get to pick the best 30-year block. It could be the best or it could be the worst. You must have a system that protects against the bad years and lets the good years run.

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