Why Does The Stock Market Go Up?

1. The Stock Market: The Greatest Wealth Creation Machine

"The stock market is the greatest wealth creation machine of all time."

Wealth creation potential. The stock market has enabled millions of ordinary people to build wealth and achieve their financial goals. Over the long term, it has consistently provided returns of around 10% annually, outperforming most other investment vehicles.

Power of consistency. Consider the example of Aaron, who invested $400 monthly in his 401(k) for 39 years, resulting in a portfolio worth over $3 million. This illustrates how small, consistent investments can grow significantly over time due to market appreciation and compound interest.

Historical resilience. Despite numerous challenges throughout history, including depressions, wars, and pandemics, the stock market has always recovered and reached new highs. This resilience makes it a powerful tool for long-term wealth building.

2. Understanding Stocks and Market Basics

"A stock represents partial ownership of a corporation."

Stock fundamentals. Stocks represent ownership in a company, giving shareholders a claim on the company's assets and profits. The stock market is a place where these ownership shares can be bought and sold.

Market indicators. Key stock market indexes include:

• Dow Jones Industrial Average: Tracks 30 large publicly-owned companies
• S&P 500: Follows 500 of the largest U.S. companies
• NASDAQ Composite: Includes over 3,000 companies, with a focus on technology stocks

Value drivers. Stock prices are influenced by:

• Company earnings and growth potential
• Investor sentiment and expectations
• Overall economic conditions

3. Valuing Businesses and Market Movements

"In the short run, the market is like a voting machine—tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine—assessing the substance of a company."

Valuation metrics. The Price-to-Earnings (P/E) ratio is a key metric used to determine a company's value. It compares a company's stock price to its earnings per share.

Short-term fluctuations. Daily stock price movements are often driven by:

• Investor sentiment and emotions
• News and events affecting the company or industry
• Overall market trends

Long-term trends. Over time, stock prices tend to follow a company's earnings growth. Companies that consistently increase their profits usually see their stock prices rise accordingly.

4. Long-Term Market Trends and Recoveries

"There has never been a 20-year period in U.S. history where the S&P 500 didn't produce a positive return."

Market resilience. Despite periodic crashes and corrections, the stock market has always recovered and reached new highs over time. This pattern has held true through various economic and geopolitical challenges.

Recovery drivers:

• Business innovation and adaptation during tough times
• Survival and growth of strong companies
• Government interventions and economic policies

Investor perspective. Understanding this long-term trend can help investors maintain confidence during market downturns and avoid panic selling.

5. Factors Driving Earnings Growth

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

Key growth factors:

1. Inflation: Gradual increase in prices over time
2. Productivity: Improved efficiency in producing goods and services
3. Innovation: New technologies and business models
4. International expansion: Companies entering new markets
5. Population growth: Increasing demand for goods and services
6. Acquisitions: Companies buying other businesses
7. Stock buybacks: Companies repurchasing their own shares

Compound effect. While each factor may have a small impact annually, their combined effect leads to consistent earnings growth over time.

Market implications. Understanding these factors can help investors identify companies and industries with strong growth potential.

6. The Power of Compounding in Investing

"Money makes money. And the money that money makes, makes money."

Compounding explained. Compounding occurs when the returns from an investment are reinvested, generating additional returns over time. This leads to exponential growth of the investment.

Real-world example. If you invested $100 monthly in the S&P 500:

• Starting in 2010, you'd have $31,177 by 2020
• Starting in 1990, you'd have $229,953 by 2020
• Starting in 1970, you'd have $2,618,060 by 2020

Importance of time. The key to harnessing compounding is investing for long periods. Starting early and staying invested consistently can lead to significant wealth accumulation.

7. Getting Started: Accounts, Strategies, and Avoiding Mistakes

"Don't let 'analysis paralysis' keep you from getting started."

Account types:

• Regular brokerage accounts: Funded with after-tax money, no special tax treatment
• Retirement accounts: 401(k), IRA, Roth IRA - offer tax advantages

Investment options:

• Index funds: Low-cost, diversified exposure to the market
• Individual stocks: Requires more research and active management
• Target-date retirement funds: Automatically adjust risk over time

Common mistakes to avoid:

• Trying to time the market
• Buying penny stocks
• Selling winning investments too early
• Chasing high dividend yields without considering company fundamentals

8. Diversification, Asset Allocation, and Rebalancing

"Don't put all your eggs in one basket."

Diversification benefits. Spreading investments across different assets can help reduce risk and smooth out returns. This strategy can protect against significant losses if one investment performs poorly.

Asset allocation. Balancing investments between stocks, bonds, and cash based on:

• Investment goals
• Risk tolerance
• Time horizon

A common rule of thumb: Subtract your age from 110 to determine the percentage of your portfolio to allocate to stocks.

Rebalancing importance. Regularly adjusting your portfolio back to its target allocation helps maintain your desired risk level and can improve long-term returns.

9. Understanding Market Terminology and Institutions

"The Federal Reserve is the central bank of the United States. The Fed was created by the U.S. Government to provide the nation with a more stable monetary and financial system."

Key terms:

• Bull market: Period of rising prices
• Bear market: Period of falling prices (20% or more from recent highs)
• Correction: Short-term decline of 10% or more

Important institutions:

• Federal Reserve: Controls monetary policy and interest rates
• Securities and Exchange Commission (SEC): Regulates financial markets and enforces securities laws

Market mechanics:

• Stock splits: Division of existing shares to lower share price
• Bonds: Debt securities issued by companies or governments
• Dividend reinvestment: Using dividend payments to buy additional shares

Last updated: November 18, 2024