So, is it that simple?

How does the market actually work?

Before talking about an extremely important subject, let’s briefly talk about how the markets work.

  Once past the IPO, stocks get listed on different stock exchanges, like the New York Stock Exchange, or the Nasdaq Stock Exchange. Through multiple brokers, people get to trade listed stocks. This means that every person or entity with an IBKR/Schwab account can buy or sell any given stock. The price of the asset will be determined by the supply and demand it has. This price, multiplied by the number of shares outstanding (issued by the business) or in circulation, will determine the market value of the underlying business, the “Market Capitalization.”

  Since the stock market inception, there have been multiple innovations to facilitate its functioning. The most impactful one, in my opinion, has been the creation of the so called “Indexes” or benchmarks. Stock indexes are a group of stocks designed to represent or reflect the performance of a stock market, country, region, industry, or category of stocks. The most representative Index of the US economy is the S&P 500. It is composed by the 500 American businesses with more Market Cap (the ones perceived as the most valuable by the market). And, since I’m in the topic, these indexes trade in the form of Exchange Traded Funds (ETF). For example, to get exposure to the S&P 500, a person could buy the ETF called SPY.

Now, to the main question 

Is it that simple then?

It’s true that the stock market has been the best performing asset class of the past century, but not everything is flowers and roses. The cold truth is that returns are not linear and this is something often skipped. The annualized average S&P return for the last century has been around the 9% but the individual yearly returns are quite revealing. In order to access that 8 or 10% yearly return, you must be prepared for the draw downs, they always come.

“The investor should know about these possibilities and should be prepared for them, both financially and psychologically.”

Not everybody has the nerves to handle a draw down, and believe me, nobody is ever prepared to suffer a 20/30% cut in its capital. It’s very important to know yourself well enough to determine whether you would be capable of losing that amount of money without losing your mind.

 Everyone talks about how if you held Apple, Amazon, Microsoft or Monster, you’d be very wealthy, their returns have been life changing. But not everyone is psychologically prepared to resist the volatility and draw downs those stocks have had. This is an example of what holding one of these stocks would have looked like:

This volatility is specially remarkable in stocks that had very high returns but its an inherent characteristic of the stock market and one that, the sooner a person accepts it, the better will it handle it. The price to pay in order to get the returns the stock market has to offer is volatility, since one can’t really predict which year will the stock market fall or by how much.

This is the reason why the main recommendation professionals give, as a rule of thumb, is not to put money in the stock market that you’ll probably need in less than three years.