This article is an excerpt from the Shortform book guide to "The Simple Path to Wealth" by JL Collins. Shortform has the world's best summaries and analyses of books you should be reading.
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What exactly is the stock market? What are some things you should know about before buying your first stock?
The stock market is made up of all publicly traded companies that issue stock—when you buy stock in a company, you own a piece of that business. To invest successfully, you must have some basic knowledge of the stock market.
In his book The Simple Path to Wealth, blogger and financial expert J. L. Collins lays out the following truths about the stock market that every beginner stock investor must accept and understand.
J. L. Collins: 5 Stock Market Truths
Investing doesn’t have to be complex. People selling investments profit by making them complicated—they convince you that you need professional help to get started with investing. Yet the actively managed funds they sell are costly and underperform index funds. According to financial blogger J.L. Collins, getting started with stock trading requires that you have basic knowledge of the stock market and that you understand the following five stock market truths:
Truth #1: The market is the most effective wealth-building tool ever. Your money should be in the market working effectively as soon as possible.
Truth #2: The market always goes up over time. You can predict that it will be higher in 20 years than it is today; it will very likely be higher in 10 years as well. The Dow Jones Industrial average started the last century at 68 and ended at 11,497 (in 2010). As investor Warren Buffett has pointed out, this period included two world wars, a depression, periods of high inflation, oil shocks, and a dozen recessions and financial panics. Despite dips, the market maintains an overall upward trajectory.
The market always goes up for at least two reasons:
- It’s self-correcting: Companies that go into decline disappear and are replaced by new ones. There’s an upward bias in the market because there’s no limit on the percentage return a successful company can deliver, but there’s a limit on how far down a company can slide—when a company’s stock loses its value, it drops from the index. All broad-based index funds self-correct in this way.
- Owning stock is owning part of a company working hard to compete and succeed in an economy that rewards the strong and eliminates the weak. So again, the strongest prevail and their stock values increase.
Truth #3: The market is volatile: Market crashes (drops of 20% or more) are inevitable—a major meltdown typically occurs about every 25 years, plus there are more frequent smaller drops in that timeframe as well as several bull (increasing) markets.
There’s always a major crash somewhere ahead—for example, on October 19, 1987, on Black Monday, the market suddenly dropped 22% or 500 points. In addition, even bigger disastrous events like the 1929 Great Depression are part of the process. Each time there’s a major drop, analysts and pundits proclaim that it’s abnormal, causing many investors to panic and sell. However, even the most alarming downturns are normal.
During crashes or bear markets (those trending downward), remember that:
- Ups and downs, including crashes, are to be expected.
- The market always recovers from a crash.
- The market is still the best investment vehicle ever.
Truth #4: Investing successfully requires accepting risk and having the discipline to stay the course during downturns. To succeed as an investor you’ll have to prepare yourself intellectually and emotionally for downturns and tough them out. If you panic instead and sell, you’ll lose.
For example, Collins lost his nerve after Black Monday and sold investments. He lost money, not only because he got lower prices when he sold, but also because he couldn’t benefit from the market’s recovery. It took him a year to regain confidence and start investing again; when he did, it cost him more money to get back into the market because stock prices were high from the recovery. From this experience, he learned to stay the course, no matter what happens.
Another mistake is to spread the risk by trying to invest a little in every kind of asset. When you do this, it’s time-consuming to understand various types of assets, determine the right allocation percentages, and track and rebalance your allocations as needed. Further, you’ll get mediocre returns over time.
One way to think of the market’s resilience is to imagine it as a mug of beer. The beer is the companies making up the market, while the foam—the most visible part—is daily prices and hype. You should focus on the beer, the company performance that drives the market higher over time, instead of the froth.
Truth #5: You can’t “time” the market: Financial analysts, pundits, and many investors try to “time” the market—that is, to make money buying or selling stocks based on predicting market performance. They might be right occasionally, but they usually get the timing wrong, buying when the market’s high (prices are high) and selling when it’s low (when they should buy instead).
The same applies to picking individual stocks: neither the average investor nor the majority of professionals can successfully pick winning stocks consistently. You’re better off investing in index funds with steady returns over time.
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- A simple road map to achieving financial independence and a secure retirement
- How to put your money to work for you as your “servant”
- Why you don't need a financial advisor to help you invest