Ch. 5: Five Principles of Stock Investing

Ch. 5:  Five Principles of Stock Market Investing

            Chapter 4 gave us a nice foundation for understanding the stock market.  Chapter 5 will give us five simple principles that every investor must understand.  There’s a pretty big difference between the skills needed to invest soundly (surprisingly easy) and the requisite knowledge to explain to others why your investing decisions are sound.  Follow my suggestions, and you will be happy with your outcomes and outperform most investors, and hopefully, be able to explain to others how you built your investing philsopophy.

Principle #1:  Transactions Lead to Price Changes

  Every time I buy stock, someone sells it to me.  Everyone I sell stock, someone is buying it from me. In our modern economy, these types of trades are arranged seamlessly through financial institutions.  So, I don’t have to concern myself with how these trades happen.  But to understand the market, you need to have a basic knowledge of the role that such transactions have on price.

  What causes a company’s stock share price to change?  Generally, it’s impacts of supply and demand.  When people suddenly want to buy an item, that item gets more expensive.  When people suddenly want to sell an item, it gets cheaper.  Through these simple mechanisms, changes in prices can reveal changes in beliefs.  For example, suppose that Pfizer (ticker symbol: PFE) suddenly announces that it has developed a cure for cancer.  As an investor, I now desperately want to own shares of Pfizer, but the current owners of Pfizer will not sell me their shares at the old, pre-cancer medication, price.  So, I will need to offer a high price to find someone to sell me shares.  Or, alternatively, imagine that the CEO of  Hyatt Hotels (H) is arrested for tax evasion.  Investors will now want to sell their shares of stock, but finding a buyer is hard, so sellers must be willing to lower their prices. 

  Thus, the price of a stock share reflects investor sentiment.  When Apple (AAPL) stock prices rise, this is a result of investors actively buying shares, driving-up the price.  When Chevron stock prices drop (CVX), this is a result of investors selling shares, driving down the price.[1]  As an individual investor, you effectively have no impact on the price of a given stock… you are just too “small” to move markets.  But there are many people like you and the market price moves in response to the actions of these many people.

Principle #2:  The Market is Forward-Looking

            Every investor really wants the same thing—to make money.  If you’re an investor using simple buy/sell transactions, then making money requires that you sell shares for a price that is higher than the price you paid to purchase the shares.  The goal is to buy-low, sell-high. 

            Considering this goal, imagine you can invest in two companies.  Company A and Company B have the same financial situation today—identical revenues, costs, etc.  However, investors think that Company A is going to be more profitable 10 years from today.  If both companies have the same share price ($5/share), then you would prefer to buy Company A, right? As such, the share prices won’t be the same!  Company A might trade for $10/share while Company B may have a share price of $3/share; these differences in prices are a reflection of different expectations about the future of these companies.  The stock market is forward-looking. 

  This explains why companies can have massive market caps and teeny-tiny revenues and small (or even negative) profits. Consider Tesla (TSLA).  In 2023, Tesla generated revenues of $25.1 Billion, yet its market cap was $659 Billion at years-end.  Comparatively, General Electric (GE) earned $68.0 Billion in 2023 revenues, yet its market cap was only $92 Billion.  GE is a bigger company today, by virtually every measure (other than market cap), yet Tesla is more valuable from a stock-market-valuation perspective since investors anticipate the firm to eventually become extremely popular.

  The same logic can be applied to the stock market as a whole.  During a recession, stock prices (as measured by the S&P 500, for example), can rise.  During the 2020 year, the S&P 500 rose 17.88% as the world around us practically crumbled to the ground.  Why?  Because investors are more concerned about the future than they are about the present.  The present in 2020 truly sucked, but investors bought stock as they anticipated government stimulus packages and low interest rates would eventually boost revenues. Current conditions matter, but investors are always looking to the future. 

Principle #3:  Stock Investors are Usually Rewarded Handsomely

  It seems that everyone I know is a cynical bastard.  They argue that the world is getting worse, people are getting lazier… blah, blah, blah.  Inherently, we are engrained to have a negativity bias.  I’ve always figured this is an evolutionary trait.  Negativity can be useful; if I worry about the lion that might eat me, then maybe I’ll turn that worrying into action and build some weaponry for defense.   Worrying might just save my life, whereas celebration doesn’t do me a whole lot of good. 

  As the time of writing, the US unemployment rate was 3.7% (great), the S&P 500 just reached an all-time high, median income is at its highest level and continuing to rise, etc.  But, US citizens remain cynical.

The graph above basically shows that Americans believe the economy has been getting worse for roughly three straight years.  This is three straight years of uninterrupted economic growth, low unemployment, improving inflation, and rising stock prices.  And I bet you’re reading this and thinking “yeah, but what about (fill in the blank)?!”  That’s your negativity bias talking, you cynical bastard.

  Cynicism be damned, the world is getting better.  And it shows in the stock market.  Remember that stock prices are forward-looking.  So, what does it mean when stock prices rise?  It means that investors are more optimistic about the future!  I type this with the market at an all-time high, meaning that investors have never been more optimistic about the profit potential of American corporations.[2]  So, tomorrow looks good today.

  Where is the market heading?  We know that investors are forward-looking, right?  I mean, if everyone thought the world would end in five years, stocks would not be attaining all-time highs.  So, let’s think about where things stand.  If stock prices rise this year, this is a result of investors’ expectations that stock prices will be higher in, say, five years, than they are today.  Now, what would make stock prices be high in five years?  If stock prices are high in five years, that must be because investors five years from now expect stock prices to be higher ten years from today.  And why would investors expect prices to be higher ten years from today?  Because they expect stock prices to be higher in fifteen years!  This logic can be applied further and further into the future. 

  Yes, bad things will happen, but the markets will recover.   The stock market shrugged off WW1, WW2, 9/11, Covid, and will stiff-arm whatever unforeseen calamity is sue to befall us in the coming decades.  The economy, humankind, and the stock market, are all incredible resilient.  (At some point, hopefully far into the future, we will not recover from some kind of catastrophic event.  Maybe an asteroid hits the earth or some maniac will go nuts with nuclear bombs.  Financially, there is no way to guard against this.  I mean, if an asteroid hits the earth, how you invested your money will be of no concern.  If something so bad happens that the stock market permanently falls to lower levels, survival will be your only concern.) 

  What kind of return can we expect from investing in stocks?  Well, over the last several decades, an investor buying a wide variety of U.S. stocks would have earned an annual return of about 10%; foreign stocks, collectively, have also earned about 10% annually.  That’s damn good.  With a 10% annual return, an investor can expect their initial investment to double in value every seven years.  But history has no obligation to repeat itself.  Future returns could be much higher or lower than 10%. 

Principle #4:  Stock Investing Is Risky

            The stock market is extremely volatile, but over long time horizons, the risk decreases.[3]  I think a little game will help explain the role of risk in stock investing.  At a casino, I offer you the chance to play a game.  I flip a coin.  If the flip is heads, you win $1,000.  If it is tails, you lose $950.  I give you the opportunity to play this game one time and one time only.  Would you play?  Many would not.  The potential to lose $950 makes this a scary game.  But, what if I let you play the game as many times as you wanted?  I bet everyone would choose to play the game over and over!  This is how stock investing “feels” to me.  Each individual day (or game) is risky.  But if I keep playing the game, I am confident that I will be a winner.  The risk of stock investing doesn’t change much through time—every day is scary—but the expected return is so high that I accept the risk.

            The image below provides annual returns (in %) for the US stock market over the last 100ish years.[4]

As you can see, there have been 25 years where the market lost value over a full year.  Such years are painful and weak investors will panic-sell.  But the wise will invest in the market accepting that volatility as just a necessary cost of doing business.  It’s like the coin-flipping game.  If you lose a few games in a row, you shouldn’t panic.  You should just keep playing the game.  If you invested $100 in 1924, you’d have more than $57,000 now.[5]  Furthermore, just like the coin-flipping game, the runs of bad luck are difficult (impossible?) to predict.  Investors that try to “time the market” in hopes of buying before market rallies and selling before market declines are doomed to perform worse than investors that buy and hold.  As the old expression goes, time in the market beats timing the market.  Tried, trite, and true.

            Risk matters and we must develop strategies to weather the downfalls.  In 2008, the market dropped 38.5%.  This was devastating to some and painful for most.  Imagine having $1,000,000 in the market to begin the year and only $615,000 at the end.  Awful.  Or, alternatively, imagine buying stocks during 2008.  It was a great year--you got to buy stocks when they were “on sale”!  Over the course of your career, you will see precipitous declines in the market and magnificent rallies.  You need to not only prepare for volatility but also accept that risk is unavoidable if you want to build wealth.

Principle #5:  The market is impossible to predict[6]

            Loads of investors try to “beat the market”, which means to perform better than the stock market, on average.  If the U.S. stock market provides an overall 13% return this year, many investors hope to earn more than 13% for obvious reasons.  But beating the market may not be easy or even possible over the long run.  Here are a few explanations as to why.

i.                         There are two sides to every transaction

  Every time you buy a share, someone else is selling it to you.  Every time you sell a share, someone else is buying it from you.  Each transaction pits you against someone else.  And the person on the other side is trying to earn a strong return, just like you.  It’s an incredibly arrogant position to think that you are more skillful than the person on the other side of the transaction. 

ii.                      Any new information is immediately priced-in

  Many investors think that they can watch the news or follow financial updates on X to get an edge.  But they can’t?  Why?  Because everyone else can do the same.  As an analogy, imagine I told you I figured out a really good way to play basketball.  My secret?  Basketball shoes!  With basketball shoes, I can jump a bit higher, run a bit faster, and improve my performance.  What a revelation!  The problem is that everyone else has basketball shoes, so this gives me no edge.  Since everyone can wear basketball shoes, it doesn’t give me an edge to wear them.  Since everyone can read the news, reading the news doesn’t give me an investing edge.

  Furthermore, when there is an important announcement, you will not be the first to act.  Why?  Because large investment firms have devoted sensational resources to being the fastest.  For example, in 2010, a company spent two years burying a wire from Chicago to Wall Street on a straight line so that they could be the first to respond to new information.[7]  The wire allowed an investment firm to respond to news in 13.3 milliseconds, 3 milliseconds faster than anyone else.  This is fast—13.3milliseconds is way faster than the blink of an eye. 

  How do investment firms use this ultra-fast speed?  In lots of ways.  But let’s think about how a new announcement is processed by large hedge funds compared to you.  Suppose Zillow unexpectedly announces it attained its highest profit ever in the previous quarter.  This is great news and should cause the stock to rise from $29 to about $33/share.  When this announcement is made, large investment firms have an automated process where this information is immediately processed by computers and the firms will purchase shares of the stock in an instant.  Due to the influx of buyers, the price will rise to $33 very, very quickly.  By the time you know about Zillow’s success story, the market will have already “priced-in” the information.  Even so…

iii.                   Most professional investors perform worse than the market

  Those investment firms with algorithms, super-speed cables, and financial geniuses, on average, perform worse than the market![8]  Financial professionals with multiple college degrees and the greatest computing software on the planet, on average, do worse than the market.  And you think that you're going to be the pros on a clunky Dell laptop?  Please. 

Conclusions

            It doesn’t take much knowledge to be a great investor.  It really doesn’t.  In fact, dead investors perform quite well, better than the experts in fact.[9]  That’s right, dead investors—I’m talking people that aren’t alive—earn stock market returns that are higher than financial professionals.  Why?  Dead investors stay in the market.  They don’t panic-sell.  They don’t let their emotions get in the way.  They just lay there in the dirt while their dead-ass carcass is getting rich AF.  Investing is easy.

End Notes

[1]There are other mechanisms that change price.  The issuance of dividends reduces the prices.  When a company purchases share of its own stock and eliminates them from the other market, its share price rises.  These are important factors for someone trying to fully understand the inner workings of the market, but you don’t need an intimate knowledge of such factors to be a good investor.

[2] Note that this doesn’t necessarily mean that life is getting better. Profits and quality of life are not perfectly linked.

[3] Or at least, it always has so far.  Who knows what the future holds?

[4] Technically, this is only the S&P 500, not the entire market.  The S&P 500 contains the largest 500 US corporations and makes up more than 90% of the entire market.

[5] I used the following website to arrive at this answer.  This is a fun site.  Check it out.  Source:  ofdollarsanddata.com/sp500-calculator/.

[6] I’m not sure I fully believe this.  There might be some that have a special skill to predict markets with some degree of success.  But you’re not the guy.  And you will have a better investment performance and save valuable time over the course of your life if you accept that you have no skill.

[7] Information from this section come from the following article. It’s a fun read.  www.forbes.com/forbes/2010/0927/outfront-netscape-jim-barksdale-daniel-spivey-wall-street-speed-war.html?sh=6c36d63c741a

[8] This is hardly a secret and there are loads of data analyses that show this is true.  There may well be fund managers that can consistently beat the market, but the vast majority don’t.  Here is a decent article.

[9] Here is a short article about dead investors.  There are many such articles online.

Key Terms

Beat the Market:  An investing goal of earning stock market returns that supersede the average return of the market as a whole.  Those that try to “beat the market” usually perform worse than the market.

Buy and Hold:  Investing strategy where the investor buys stocks (and/or other assets) and hold this as long as possible.  In doing so, the investor can effectively ignore the volatility that is inherent to the market and take advantage of as much growth as possible.

Financial Institutions:  Banks, investment firms, mortgage lenders, etc. 

Panic Sell:  Selling stock (and/or other assets) during a market downturn.  The goal is buy-low, sell-high.  Selling when the market has declined is counter to our investing goals.

Practice Problems

This chapter had no math and the concepts were pretty straightforward, right?  No practice problems needed, but make sure you understand the content!