Author, columnist, stock analyst and financial educator Brian Feroldi believes that understanding the core structure of the stock market can positively impact your behaviour.
In his book Why does the stock market go up, he simplifies the stock market language to help regular folk invest with confidence. Here's what he has to say on the subject.
Why is it so important to understand the basics?
Once you understand the underlying forces that cause the market to hit new highs, you can invest with confidence. It will also help you hold on to your stocks and continue to add when the market is declining. Understanding the core structure of the stock market can positively impact your behavior.
In my book, I broke it down by getting into the individual components, and I started by talking about a fictional coffee company. If you start at the individual business level, you can then scale it up into the stock market.
So the goal of my book was to establish that link between the price that you see in the market, which is apparent, and business profits. Explain why corporate profits have risen consistently over long periods of time, for the last 150-200 years, and lay out the case for why that should continue to happen.
What is a stock?
A stock literally represents fractional ownership of a corporation. Stocks were invented because they vastly simplified the record keeping for who owns how much of a given company.
When you become an owner, a shareholder of a company, you now have a legal claim on that company’s assets, what it owns, and that company’s current and future profits.
As a company generates profits, those profits don’t belong to the company. They belong to the owners of that company, which are the shareholders. By and large, the earnings or the profits of all of the companies in the S&P500 tend to rise over long periods of time. Now, there are many underlying factors that cause those profits to rise, such as population growth, inflation, innovation, stock buybacks, and productivity.
But broadly speaking over long periods of time, the companies in the S&P500 tend to become more and more profitable. A shareholder of those companies has a legal claim on a never ending stream of growing profitability. For that reason, the value of the S&P500 tends to go up when measured over long periods of time. Although, over short periods of time, the stock market can visit some very interesting places.
Why does the stock market go up?
Why does any business that has generated strong returns over long periods of time go up? The answer is that the business behind that stock grows its revenue, expands its margins, and increases its profits dramatically.
Take a look at any of the best-performing stocks of all time--Apple, Microsoft, Amazon, Netflix, and so on--and ask yourself, why are these companies worth so much more today than they were 10 years ago, 20 years ago, 30 years ago? The answer is their businesses are many, many, many multiples bigger today than they were 10 and 20 years ago. I think that that concept is relatively straightforward to understand to somebody and you can make them understand why those stocks gradually went up over time as the businesses were succeeding.
Many people don’t understand that there’s a direct relationship between the price of the stock market and the profits of the businesses that are in in the stock market. Once I discovered that there was a direct relationship, in the long term, between how businesses performed, the profits that those businesses produced, and the prices that their stock trades at, that’s when it all suddenly made sense.
Related Reading: If you want to buy stocks, read this to start off.
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