Alyssa McNamara Reed, CFP®
CERTFIED FINANCIAL PLANNERTM
Let’s talk about the stock market, and how it is basically irrelevant to an investor. First, let’s define what a stock is. A stock is partial ownership of a company. When a company is profitable, it will share its profits with its shareholders in the form of dividends. Receiving dividends is one way that you can earn money when you invest in a stock. The other way that you can earn money investing in stock is when your stock becomes desirable to another person or entity. There may be a time when someone is willing to pay more for your stock than you paid for it. This is share price appreciation. You made money by selling higher than you bought.
Okay, now we can talk about the stock market. The stock market is a store where people/entities can go to buy and sell stocks. This stock market store behaves like many other retail stores. If you walk into a clothing store, the most desirable items (in-season, in-style, best colors) are priced the highest. The least desirable items are in the back on clearance. This is basic economics. The stock market works the same way. When stocks become desirable, more people are buying than selling, the prices increase, and the market goes up. When stocks become undesirable, more people are selling than buying, prices fall, and the market goes down.
But here is what you should ask yourself: why do stocks become desirable or undesirable? A political situation? An election? A jobs report? One company’s quarter-end earnings? An economic indicator? An investment professional predicting the future? It could be any number of things, probably very few of which have anything to do with the profitability of the companies issuing the stocks in the market. Let’s not forget that most of the people shopping at this stock market store are not financial analysts, and are making guesses or emotional decisions based on something in the news. Let’s also not forget that the news tends to be very dramatic. The stock market is a culmination of emotional decisions, and is not an indicator of companies’ abilities to earn money and increase their worth. If a company continues to increase its profits over time, its shares of stock will inevitably become more valuable (this takes many years), and investors in those companies will make money.
When the stock market is down, stocks are on the clearance rack. But just because other people are selling their stocks, doesn’t mean you should sell yours. And it doesn’t mean you should be nervous to buy them. In fact, it’s a great time to buy them. Haven’t we all found some great stuff on those clearance racks in the back of the store? I am writing this article on 10/24/2013 when the S&P 500 is up 23% year-to-date. I want you to be ready when the inevitable correction comes. Don’t get consumed by the emotions in the stock market store.