But it’s also completely accurate, because I really can teach you the best way to make money from the stock market all in one short blog post.
Some of our readers are already advanced investors.. those few people already know all of this and the article will just be preaching to the choir.
But the reason I’m still writing is that almost nobody I meet in day-to-day life knows anything about investing, the stock market, or big publicly-traded companies in general. Their opinions on the subject range throughout boredom, fear, mistrust, and if they are lucky, curiosity. Or if they are unlucky, bold confidence in their abilities to drastically “beat the market” with their intuition.
Here are three real quotes I have heard from friends over time when discussing the stock market.
“I don’t know what my retirement money is in.. I just checked some boxes on the sheet when I started my job, but I don’t really understand it”. “I don’t really believe in mutual funds at all – I’m dedicated enough to do my own research and I can pick winning individual stocks.. I’ve got some Apple, some Google, some Crude Oil/Gold/Pig’s Feet/whatever…..”
“I don’t know what my retirement money is in.. I just checked some boxes on the sheet when I started my job, but I don’t really understand it”.
“I don’t really believe in mutual funds at all – I’m dedicated enough to do my own research and I can pick winning individual stocks.. I’ve got some Apple, some Google, some Crude Oil/Gold/Pig’s Feet/whatever…..”
All three of these approaches are understandable, but wrong.
The sentiments are valid and I’m glad that people at least have an opinion, but each represents a lack of knowledge about the statistics that run the whole system. Knowing the nature of the market is the key to being able to invest huge sums of your money over time with the absolute confidence that you’re not doing anything stupid.
It’s worth gaining this confidence, because investing knowledgeably in stocks has always been the single best thing to do with your money in terms of getting lifetime income with absolutely no effort on your part.
To start with the basics – What is a stock?
It’s a slice of a company that you truly own. When you own a share, you have the right (but not obligation) to attend the shareholder’s meeting for that company, vote on important company decisions, and you have a right to a share of any future earnings that company makes. This share of earnings is called a Dividend.
In some companies, especially smaller or younger ones, the company elects (with the permission of its shareholders) to reinvest the dividends to help the company grow its earnings even faster. In theory, this means you will get more dividends in the future. Thus, the real value behind any share in a company is the right to get a never-ending stream of dividends from it.
For Example, the old, long-profitable company Lockheed Martin currently pays a 3.8 percent annual dividend while growing slowly, while Apple Computer, fancying itself a high growth company, pays zero percent right now and reinvests all profits for faster growth.
Why do stocks go up and down so much?
The true value of a stock is based on the amount of dividends this stock will eventually pay you, the shareholder, over time. That dividend depends entirely on how much money the company will make.
But nobody actually knows in advance how much money companies will make – they just have a big host of differing opinions. Every day, millions of investors and analysts scurry around and worry about how much money each company will make in the future.
“The US economy is slowing down! This means people will drive LESS to the shopping mall and buy less gas! Oil demand will go down and oil companies will make less! Sell! Sell!
It’s a neverending din like this, for every single stock, on every single stock exchange, throughout the world.
If stocks are so crazy, how can I make money off of them?
Because in the LONG run, it turns out that all this speculation and volatility always cancels out to absolutely zero.
The value of stocks will go up as the earnings of the underlying companies goes up. A portion of the ongoing earnings will always flow to the shareholders as dividends. And all this happens because of the natural ingenuity of hardworking humans making things at a profit, and continuing to advance our knowledge and technology and make us all more productive in every field.
There may come a time when we can no longer advance, but based on the fact that we’re still driving around in gas-burning tanks and Home Depot is still doing all of its computing on green-on-black mainframe computers that kick you back to the beginning of the order if you make a typing mistake, I’d say we have at least a lifetime left to go in this department.
So, stocks go up and pay dividends over time, and they have since the beginning of modern commerce. The total return has averaged a very lumpy but fairly dependable 10 percent per year before inflation, 7 percent after inflation.
5 of the 7 percent comes in the form of rising stock prices, and the other 2 comes from dividend payments directly from the company to you. When you’re in your ‘Stashing stage, you just let these dividends automatically reinvest in more stocks which creates a nice compounding effect.
But WHICH stocks do I want to buy to make this free money?
This is the easy part. You buy ALL of them.
The best minds in finance have done countless studies on this for over 40 years. What they find is that the best way to make money in the stock market is to simply buy an “index fund”, which is a mutual fund that automatically buys appropriate ratios of every major stock in your country’s stock market, with no magic and guessing of which stocks are better than others.
The reason the index fund wins statistically is because it can be run by a simple automated set of rules – no need to pay 350 million dollar salaries to the hotshot traders running the “Aggressive Growth Fund” down the street. Because there are millions of people, both smart and dumb, squabbling over the value of each stock, the Index Fund benefits and suffers from all the individual stock performances. But overall, you get the average performance of all this squabbling.
If you descend into the pit and try some squabbling yourself, you may come out ahead or drastically behind the average, but as it turns out, you can’t predict in advance which squabblers (including yourself) will win and which will lose. All you can predict is that your average performance if you buy enough of these funds will be equal to the return of the market as a whole, minus the amount of fees your mutual fund charges.
So by picking the index fund with the lowest fees, you automatically win. Endless statistical analysis proves this again and again. If you don’t believe me, read the book “A Random Walk Down Wall Street, or look up the topic of John Bogle / Bogleheads / and the foundation of the Vanguard company itself.
But my uncle bought some stocks once and sold at a big profit! Also, if index funds really are the statistically best bet, why are there still thousands of brand-name mutual funds and hotshot traders out there?
For the same reason that Las Vegas still exists and people still drive SUVs.
Humans are irrational creatures and it is scientifically proven that we overestimate our own investment (and gambling) abilities, and no presentation of knowledge to the affected people can completely erase this. I have some perfectly intelligent friends who still believe they are “lucky” at games of chance, even though any scientist in the world can quickly run an experiment to irrefutably disprove the existence of any form of luck.
The only tool you can truly use is statistical probability, and by buying the market average and lowering your investment costs, you are improving your statistical chances.
OK, Fine. Which Index fund do I want?
There is one king index fund that makes the decision easy for you. The Vanguard Total Stock Market Index Exchange Traded Fund (VTI) tracks the entire US stock market index.
Its expense ratio is 0.04%. This means that for every $100,000 of shares you hold, they subtract $40 per year from their gains to pay for their offices and trading costs. Some funds charge 10-20 times higher fees. So if you are looking over employer-sponsored plans, try to find a total stock index fund (or at least its close cousin the S&P 500 index fund), and compare the expense ratio to 0.04%.
What is the S&P 500?
This is a collection of shares in the 500 largest companies in the US, and therefore in most of the world. They are all multinational companies, so they benefit from growth around the world. If you really want to invest without having to worry, the S&P represents good odds. If you buy the stock market index of a smaller country, like Canada, you will still have good odds, but at higher volatility. (During the dot-com boom of the nineties, a company called Nortel once represented 70% of Canada’s entire stock market value. This company is now bankrupt, so you can imagine how that felt to investors solely in the Canadian index. Now Canada is the new Saudi Arabia with oil exports, so its index is again riding high on oil company stocks. I wouldn’t bet my whole Mustache on that one commodity either).
What about International stocks?
Some people like to get fancy and buy international index funds, which can do well when the US is hurting (as it has been recently). This is fine, as long as you understand that it’s just another form of trying to outsmart the basic stock index.
When you do this, you are stating that you believe the stock markets of the other countries are more undervalued relative to future growth, than the US market is. The US is traditionally the most business-friendly country in the world, so its stock index has tended to have the highest performance, after taking into account its lower risk and volatility compared to, say, throwing all your chips onto Russia or China.
It may or may not pay off in the future – I just want to point out that most people just make this decision on a whim, something like “China is so hot right now, they’re taking over the world!” . Whereas to actually justify international investing rationally you’d have to be a very sophisticated investor and truly understand WHY you are doing it.
So there you have it – in two words: Vanguard.com, and VTI. In Canada, check out TD Waterhouse and their own series of funds, and let me know if you have any questions about what you find there – MMM has a Canadian Investments Expert Panel that can help us out.