For many people the stock market is a scary place, to be avoided, because of its reputation as a place where you may lose your shirt. This is true, but it’s only dangerous if you treat it like a casino.
Ownership of companies is the best game in town. Over the years the mass of stocks tick upward in value, at a rate of about 10% a year. It’s the most fantastic money-making vehicle ever devised. We buy in as a part-owner in our civilisation, and it’s a civilisation which keeps advancing.
I say “in value”, meaning the underlying worth of these building blocks of our civilisation, but that’s not the same as saying “in price”. The prices wobble about all over the place, as the market prices are determined by the buyers and sellers. In the short term it can be very unstable, and this scares a lot of people off.
This price volatility also attracts gamblers, who see the opportunity for quick wins. We’re not interested in playing that game; we’re here as long-term buyers to take advantage of the slow growth over the years. If we zoom out and look at the longer term, the volatility is no longer visible and we just see the upward curve.
Using a pound to buy a stock is like putting it onto an escalator. It’ll start to go up.
The growth isn’t just linear. Your pound will eventually double to become two pounds. If you let them continue riding the escalator, when they come out at the next level they’ll be four pounds. And so on. The growth “compounds”.
Let’s break down the jargon and see how this works. “Stock” means owning shares in a company - you become a part-owner, usually with a very small slice. Your company makes a profit, and the owners are entitled to the profits.
The company will either pay profits out to the owners, known as paying a dividend, or they’ll retain it within the business to grow operations. Eventually this should result in the value of the company growing and the share price will go up to reflect the added value. Often a company will use a combination of these two things.
If you as an owner want to take some income from your ownership, you can do it in two ways. You can take your dividends, and you can sell a small number of shares. Equally if you don’t require the income just now, and would prefer to leave the money to grow your ownership, you can reinvest the dividends to buy some more shares, and in the case of those retained profits you just don’t sell any shares and wait for the share price to go up over time.
Whilst you’re still building your wealth toward Financial Independence, you’d do the latter and let all the money ride, so that your wealth grows at the quickest possible rate.
Once retired, you’d take your dividends and sell some stock regularly to give yourself an income.
Index Funds
You most likely don’t want to become an expert spending all of your time studying companies to get the right ones. And you don’t want to put all of your eggs in one basket - after all, some companies fail. So you buy an Index Fund (or to use a longer name, a passive global index tracker fund). Big shout to a guy called John Bogle who invented this and made investing accessible to everyone.
Index funds mean that you own a tiny slice of thousands of companies. If one goes bust, you don’t notice. The index replaces the losers (generally before they actually go bust) with the new rising stars, and from your viewpoint this is all automatic. All you see is that you put £20 in, and at some point in the future this will be worth £100.
The stock market is full of all sorts, and this makes a lot of people wary of getting involved. It’s a place that gets used by startup companies who boom and then often go bust; by people trying to get rich quick and the people who would con them; and by a lot of boring dependable profitable companies and their quiet owners. We want to ignore all of the hoopla associated with short-term trading and trying to get rich quickly, and instead just get the benefits of being on the escalator ride. The index fund does that.
An index fund isn’t immune to all of the problems of the stock market. It’s a reflection of our civilisation, so it has good years and bad, it reacts to wars and disasters, but over the long-term it has ticked upward at a rate of about 10% a year. That makes it a remarkable wealth-building vehicle that we definitely want a piece of. But we must take that long-term view. In the short-term, it may drop 10% or 20% this year, and the media will cry out that the sky is falling. Equally it may rise 30% next year, and of course the media don’t shout this so loudly, because good news doesn’t sell newspapers. We need to be disciplined and keep riding without giving way to panics, remembering that the prices always go back up and deliver us record-breaking wealth if we just wait long enough.
Volatility
If there’s a war in Europe, buyers get all nervous and demand dries up. Prices dip. This often has nothing to do with the continued profitability of the individual stock - it’s just the way that the market acts.
Similarly the market will frequently over-react to news about a company. Their quarterly report says that they only hit 95% of their sales target - and the shares may dip by 20%. Hang on, you say, this is out of proportion. Yes! It’s the craziness of markets.
People go to the market for different reasons. A lot of gamblers go there looking for a quick profit. They’re the ones who over-react to that sales target near-miss. They don’t have any patience - their timeframe is weeks or months, so when they see a short-term wobble they’ll sell up and go prospecting elsewhere. This is very different to someone with an owner’s mentality, who’ll be there for the long-haul, and will see these temporary price dips and treat them as a buying opportunity. “They’re having a sale, let’s load up on the cheap”.
This mixture of behaviours means that we have to endure a roller-coaster ride of prices, even if the companies we own are steady profit-makers. This adds a psychological problem. We are wired to panic. If we see everyone rushing for the exit, we feel compelled to join the crowd, even if logically we know that there is no good reason for it. We must learn to resist this crowd-following behaviour, to not sell out and crystallise a loss, to keep holding long-term as long as our original investing thesis remains sound. Are those companies you bought still a good idea? Has anything fundamental changed? If not, you don’t need to do anything.
The proof of this need for inaction is found in the stats from the investing platforms, who regularly tell us that the most successful investors are the ones who have either died or forgotten about their account. The guy who loses his login details is a pretty successful investor!
An added complication is the media. They have a vested interest in getting clicks, so they need to come up with sensational stories. If you can learn to filter out the media noise, or at least just stick to more conservative sources, you’ll feel less pressure to react and panic.
Time In The Market beats Timing The Market
As an index investor, the best approach is to be a regular and steady buyer, ignoring market events. It’s difficult to time the market accurately, so you are better off not trying. If you hold off investing till the right moment when the price dips, you are likely to miss out on a recovery in prices. You are better off invested. There’s an old saying “time in the market beats timing the market”. While you try to wait for a good moment, the underlying value of the business is ticking upward at a rate around 10% a year.
Once you are retired and are drawing down income from your investments, you face even more of a timing challenge. There will be times when you are a forced seller, to pull out the money you need for your spending. When the market is down, this can be painful. You are pulling a bigger chunk of shares to cover your spending, and if this continues for a long time it can be damaging to your portfolio as there will be fewer shares left to bounce back up when the price recovery comes. This is known as Sequence of Returns Risk, and it’s the main threat to the survival of your portfolio. We’ll talk about this in depth in the article on risk.
An Owner’s Mentality
Once I’ve bought, I’m an owner for the long-term - decades. My profit is coming when the company makes a profit on its operations. Okay I’m only a small part-owner, but I still get my little slice of the profits, and this doesn’t much depend on what the share price does. The market can go haywire all it likes, I still own the same slice of my businesses, and as long as they’re still trading, still making a profit (though perhaps temporarily a bit reduced in bad economic times), then my ownership is still intact. The company’s operations produce cashflows, irrespective of the share price.
If share prices tank to half of what they were, it doesn’t hurt me if I’m not selling.
This mindset is pretty easy to maintain during the accumulation phase. In a downturn, that means fresh shares are on sale at bargain prices, and my monthly contribution gets me more shares than usual. But it’s during retirement that I have more of a problem, as I’ll be looking to pull my income from that shareholding.
It’s still not a massive problem. Part of the profits pop out anyway as dividends. Even if companies retain some of their profit to reinvest, there’s usually a dividend portion, and this is the same in index funds too - there’s generally an annual distribution. You just need to switch to distribution units rather than accumulation units if you want that money to pop out as your passive income rather than being reinvested.
The painful part is selling some shares/units for income, if the dividends don’t cover all of your needs. Reducing your number of shares whilst the share price is down means that you end up selling a bigger number to cover your spending.
Naturally we all tend to exercise a bit of restraint when the market’s down. This is a good approach - it means that skipping that expensive round-the-world trip until the market is a bit better helps defend your portfolio from you deep-dipping into it. This sort of restraint is often all that’s needed in order to weather the storm successfully. It’s known as flexing, and being willing to flex down from 4% to say 3% when things are bad is enough to weather most of the bad scenarios you are likely to meet.
Other assets
Of course, stocks are only one type of asset and some people are strongly sold on alternatives. For me these are all inferior, as they don’t shape up compared to shares either on the profit making potential (I’m thinking bonds and cash deposits here) or not actually being passive (Buy To Let!).
Other assets can be worse still, if they’re not productive and are just a speculation on the price going up. (Think gold, cryptocurrency, artworks.) These things can’t be assigned a value based on what they produce, because they produce nothing. This means that they’re ultimately just a form of gambling.
Having dismissed the alternatives, we need to be realistic about stocks - depsite their great profitability, they comes with risks, and we’ll look at those next.
Continue to Risk