10 truths about the stock market 📈
A mental framework for investors
The stock market can be an intimidating place: it’s real money on the line, there’s an overwhelming amount of information, and people have lost fortunes very quickly.
But it’s also a place where thoughtful investors have long accumulated a lot of wealth.
The primary difference between those two outlooks is related to misconceptions about the stock market that can lead people to make poor investment decisions.
With that in mind, I present to you ten truths about the stock market.1
1. The long game is undefeated
There’s nothing the stock market hasn’t overcome.
“Over the long term, the stock market news will be good,” billionaire investor Warren Buffett, the greatest investor in history, wrote in an op-ed for The New York Times during the depths of the global financial crisis. “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
Since that op-ed was published, the market emerged from the global financial crisis. It also overcame a U.S. credit rating downgrade and a global pandemic among many other challenges. The Dow closed Thursday at 34,912, just 2% from its all-time high.
Btw, historically you didn’t have to wait a hundred years for positive returns. Since 1926, there’s never been a 20-year period where the stock market didn’t generate a positive return.
While stocks usually go up over much shorter periods, the odds of positive returns improve as you lengthen your time horizon.
2. You can get smoked in the short-term
Bull markets come with lots of bumps in the road.
While the S&P 500 has usually generated positive annual returns, it’s also seen an average drawdown (i.e. a decline from its high) of 14% during those years.
The chart below from JP Morgan Asset Management does a nice job illustrating this. The grey bars represent each calendar year’s return and the red dots represent the intra-year drawdowns.
Bear markets are no picnic either: They can happen quickly, like the S&P500’s 34% drop from February 19, 2020 to March 23, 2020; and they can happen painfully slowly, like the 57% decline from October 9, 2007 to March 9, 2009.
Investing for long-term returns means being able to stomach a lot of intermediate volatility.
3. Don’t ever expect average
At some point in your life, you probably heard that the stock market generates about 10% annual returns on average.
While that may be true in the long run, the market rarely delivers an average return in a given year.
Check out the chart below from Ritholtz Wealth Management’s Ben Carlson. It plots the S&P 500’s annual returns since 1926. If 10%-ish returns were commonplace, you’d see a tight horizontal line of dots just above the x-axis.
This chaotic mess of dots illustrates just how difficult it is to predict what next year’s returns are going to be. This holds true even if you know exactly what’s going to happen in the economy. Outside of the Great Depression and the Global Financial Crisis, it’s difficult to make out history’s major economic booms and bust.
The good news is most of the dots are above the black line. Indeed, stocks usually go up.
4. Stocks offer asymmetric upside
A stock can only go down by 100%, but there’s no limit to how many times that value can multiply going up.
Yes, we’ve seen some pretty bad sell-offs in the stock market. But it’s gone up manyfold more. It’s not guaranteed, but it’s offered. From its low of 666 in March 2009, the S&P 500 is up more than 6x today.
5. Earnings drive stock prices
Any long term move in a stock can ultimately be explained by the underlying company’s earnings, expectations for earnings, and uncertainty about those expectations for earnings.
News about the economy or policy moves markets to the degree they are expected to impact earnings. Earnings (a.k.a. profits) are why you invest in companies.
6. Valuations won’t tell you much about next year
There are many valuation methods that’ll help you estimate whether a stock or stock market is cheap or expensive. We won’t go through all of those here.
While valuation methods may tell you something about long-term returns, most tell you almost nothing about where prices are headed in the next 12 months. Over short periods like this, expensive things can get more expensive and cheap things can get cheaper.
It’s worth noting that prices can be cheap or expensive for extended periods of time. In fact, some folks would argue valuations are not mean-reverting.
7. There will always be something to worry about
Investing in stocks is risky, which is why the returns are relatively high.
Even in the most favorable market conditions, there will always be something keeping the most risk-averse folks on the sidelines. For more, check out Yahoo Finance Morning Brief’s chart of the decade.
8. The most destabilizing risks are the ones people aren’t talking about
Surveys of market participants will yield lists of top risks, and ironically the most commonly cited risks are the ones that are already priced into the markets.
It’s the risks no one is talking about or few are concerned about that’ll rock markets when they come to surface.
9. There’s a lot of turnover in the stock market
In fact, it’s the addition of new and unexpected companies that have been driving much of the S&P 500’s returns over the past decade.
10. The stock market is and isn’t the economy
While the U.S. stock market’s performance is closely tied to the trajectory of the U.S. economy, they’re not the same thing.
The economy reflects all of the business being conducted in the U.S. while the market reflects the performance of the biggest companies — which typically have access to lower-cost financing and have the scale to source goods and labor more cheaply.
What all of this means
We could very well be on the brink of a dreadful, multi-year long bear market. Who knows?
However, the stock market has an upward bias.
This makes sense if you think about it. There are way more people who want things to be better, not worse. And that demand incentivizes entrepreneurs and businesses to develop better goods and services.
And the winners in this process get bigger as revenue grows. Some even get big enough to get listed in the stock market. As revenue grows, so do earnings.
And earnings drive stock prices.
The “stock market” is a general term usually used to refer to the major U.S. indices: the Dow Jones Industrial Index, the S&P 500, and the Nasdaq. When I refer to “stocks,” I’m usually referring to the S&P 500. When discussing specific stats, I’ll be explicit about what I’m talking about.