5
Stock Market Fundamentals

“Be fearful when others are greedy. Be greedy only when others are fearful.”

—Warren Buffett, “2004 Letter to Berkshire Hathaway Shareholders”

Introduction

What is a stock? As we noted in Chapter 1, stock (also known as equity in the singular or equities in the plural) represents part ownership of a business. Buffett learned this point from his mentor, Benjamin Graham, and never forgot it. It's such an important point according to both Graham and Buffett that we'll put it as a Tip.

If you own all of the shares outstanding, you own 100% of the business. If you own 1% of the shares outstanding, you own 1% of the business. Shares outstanding are the amount of shares held by all investors of a firm. The number of shares outstanding is determined by policies set forth by the board of directors (BOD), which we previously noted is the group formally in charge of a firm. Sometimes there is a lag, typically ranging from a few months to a year, between when the shares are authorized by the BOD and when they are purchased by investors. This gets at the heart of how stocks are “born.” It's probably not as exciting as your first “birds and bees talk.” But we won't tell you stocks come from the stork. :-)

Initial Public Offerings (IPOs): The Birth of a Stock

Regarding the birth of stocks, we're going to focus on publicly traded stocks. The type that trades on a stock exchange and that anyone with enough money can own. We made the distinction between publicly traded stocks, such as Berkshire Hathaway and Apple, and privately held firms, such as the New York Yankees, the Dallas Cowboys, and Fidelity Investments.

Why do some firms go public and list their shares on a stock exchange? First, they get money for selling a piece (usually starting at 10–20%) of themselves. This money can be used to help the firm grow by developing new products, entering new markets, and many other approaches. Second, it gives existing shareholders a chance to cash out by selling their existing shares to new shareholders. It's harder for shareholders of a private firm to turn their shares into cash. Why? Shares trading on an exchange are more liquid (a term we introduced in Chapter 3) than shares of private firms since they trade every weekday, minus holidays. Third, it may make it easier to buy other companies, most of which have a preference to be acquired by public firms. Fourth, public firms generally attract more publicity than private firms. They are also more closely followed by Wall Street. Other than perhaps sports teams, can you think of any private company that gets more attention than public firms such as Apple, Alphabet, Facebook, Amazon.com, and the like?

Investment Banks and Investment Bankers

Okay, so let's say your firm, let's call it TJL Industries, wants to go public. The next step is to hire a firm to help you accomplish this goal. The firms that handle this task are called investment banking firms, and the people who work for them are called investment bankers. Some of the leading firms active in the investment banking business include Goldman Sachs, Morgan Stanley, and J.P. Morgan. If your firm is in great demand, like Uber was in 2019, the investment banking firms will compete for your firm's business, telling you why they will do a great job for your firm. This process of competition for raising money for a firm is called on Wall Street a “beauty contest” or “bake-off.” Maybe not as exciting as the Miss America or Miss Universe pageants, but it's also important. Let's say TJL Industries picks Goldman Sachs as the winner. Goldman would be called the lead underwriter in this instance. It's a term we'll flesh out in a moment since other investment banking firms may help out as well but in a lesser capacity.

The next step is called a roadshow, where Goldman's investment banking team takes the senior management of the firm (TJL Industries) to meet with potential investors. These investors may be large financial firms, such as BlackRock, Fidelity Investments, and Prudential Investments, as well as individual investors. Large firms and rich investors, often called high net worth (HNW) investors, typically receive the lion's share of new stock offered by the firm (TJL Industries).

Goldman gathers information from these investor meetings regarding the demand by investors for the stock. Goldman also looks at the prices of similar stocks in the same industry trading on the exchange, known as comparable firms, to get an idea regarding how to set the initial price the stock. (After it begins trading on the exchange, its price will be determined by the market forces of supply and demand.) The investment bankers and the firm set a price for TJL's stock that will be sold to (mostly) institutions and HNW investors. Let's say it's $20 a share and that the firm has 50 million shares outstanding. This values the firm at $1 billion, or $20 per share times the 50 million shares outstanding. But remember, the firm usually sells just a small part of itself when it goes public. Let's assume it's 10%. So Goldman helped TJL Industries raise $100 million in our example. The investment bank earns a fee of about 7% of the money raised in deals, which comes out to $7 million. For larger deals, the investment bank earns a smaller fee on a percentage basis (e.g., 2–5%).

For large deals, and occasionally smaller deals, the investment banks become sort of frenemies and combine to take the firms public. When they join forces, like in The Avengers, X-Men, or Suicide Squad movies, this group of underwriters is called a syndicate, and they share in the fees and work. The basic idea behind the syndicate is twofold. First, in a firm commitment offering, the investment bank (Goldman Sachs) guarantees it will raise the full amount ($100 million). If it significantly overestimates the demand for TJL Industries' stock, it “takes the L” and is on the hook for $100 million. Ouch!

Second, if several investment banks promote TJL to their clients or customers, it may increase demand for the stock. Two, or many, hands are usually better than one when trying to complete an important task. The investment banks sometimes put an advertisement, called a tombstone, in a financial newspaper to help drum up demand in the offering. It's nothing to freak out about, like seeing Jason from Friday the 13th in a cemetery. The name comes from the rectangular shape of the ad, similar to most gravestones.

The Main Event: The Stock Begins Trading on the Exchange

Now we're ready for the main event, the initial public offering, or IPO for short. In our example, 5 million shares of TJL Industries were sold primarily to various “connected” investors, such as big investment firms and rich individuals, at $20 a share. The $100 million raised, minus the $7 million fees paid to the investment bankers, goes to the firm doing the IPO (TJL Industries). The firm will use this money to support its future growth plans.

What about everyone else? Can't they get a piece of the action? Let's call them John and Jane Public. They can buy the stock when it starts trading on the exchange, typically a few weeks after the roadshow. But the catch is they won't likely be able to get it at the $20 a share price that the connected investors got it at. Since anyone can now buy it the morning it trades on the stock exchange, there is usually a big jump in price. Let's say to $25. Bummer. A 25% jump in price on day 1 of the IPO is fairly common, but during periods of investor craziness or euphoria, jumps of more than 100% in a single day are not unheard of! Investors often rush to get in on the “ground floor” of something they think will be big. They are hoping for the next Apple, Google, Starbucks, or Berkshire. Of course, very few firms meet these lofty expectations.

You might be thinking, “Who sells the shares to John and Jane Public?” Some of the connected investors sell, even though it may slightly anger the investment banks and the firm that just did the IPO. These investors who sell quickly after the IPO occurs are called flippers. Maybe you've seen a show on TV about flipping houses or cars. Well, it's the same concept, except with stocks. Investors that flip a lot may be cut out of the next deal by the investment bankers, since companies prefer stable, long-term investors.

Another question you might have is, “How do companies raise money after an IPO?” The process is very similar to what happened with the IPO and also involves the help of investment bankers. The term secondary or seasoned offering refers to the sale of securities by a firm that is already public. The process is a little more straightforward, and the fees are lesser on a percentage basis since the firm is already well known by investors.

There's also a special group of traders at the exchange called market makers, who always have shares available to buy or sell—at a price. You may not like the price ($25 in our example), but they are like 911—always there when you call or, in our case, trade. Most trading is done online these days, but they still have telephones. Let's talk a bit more about the stock exchange. How it works is not that much different than trading football cards, Beanie Babies, Hot Wheels cars, or anything else you traded with your friends as a kid.

The Stock Exchange

The stock exchange is a place for trading shares of a firm that have already been issued, such as after an IPO or seasoned offering. When the firm raises money from investors with an IPO or seasoned offering, it's called a primary market transaction. The trading of shares on an exchange after these primary market transactions have occurred is called secondary market transactions. So, as we said a minute ago, it's like investors trading the equivalent of football cards or Beanie Babies that were purchased in the past. If you think in these terms, it's easy to see that the firm gets no money in these secondary market transactions. Just like Apple gets no money if you resell your iPhone to another person. It's simply people trading on the side. Except there is a lot of trading on the exchanges—often over a billion shares in a single day!

There are two main stock exchanges in the US, the New York Stock Exchange (NYSE) and the National Association of Security Dealers Automated Quotation System (NASDAQ). There is also a third, smaller stock exchange, the NYSE American, previously known as the American Stock Exchange (AMEX). All three of these stock exchanges are headquartered in Manhattan.

The exchanges are open for business Monday through Friday from 9:30 a.m. to 4:00 p.m., Eastern Standard Time (EST), except for holidays. This typically results in 252 trading days a year. One factoid that may interest you is that the stock exchange typically closes for one day, soon after a former US President dies. There's also a bit of trading outside these normal hours in what is known as after-hours trading. The only thing is that this after-hours trading may occur before the market opens (4:00 a.m.–9:30 a.m. EST) and after it closes (4:00 p.m.–8:00 p.m. EST). The bulk of these after-hour trades occur two hours before the market formally opens and two hours after the market closes. It should really be called “outside of regular market hours trading,” but the term after-hours has stuck. Occasionally, it's called extended hours trading to better reflect the times available for trading.

Today, it doesn't make much difference on what exchange a stock trades. In the past, it was sort of a big deal for a company where your stock traded. Kind of like the difference between the coolness factor of driving a sleek Mercedes and a plain Chevy (not a Corvette!). Historically, it was prestigious if your stock traded on the New York Stock Exchange, which went by the nickname “the Big Board.” The name refers to a time before computers where stock prices were written on a chalkboard or came out of a ticker tape machine.

You might get a kick out of seeing a picture of a ticker tape machine. A ticker tape machine built by Thomas Edison's firm is shown in Figure 5.1. (Thomas Edison, of course, was the inventor of the modern-day lightbulb.) Perhaps you've heard the term ticker tape parade. For example, when the Yankees win the World Series in baseball, New York City holds a parade for them. The players and coaches are driven down Broadway in Manhattan, and people throw bits of paper at them in celebration, similar to confetti. In the past, the paper was mostly ticker tape. Today, it's mostly shredded paper. A ticker tape machine looks sort of like a big lightbulb that would spit out thin strips of paper. On the strip of paper would be the stock symbol (T for AT&T, as an example), the stock price ($45 a share, for example), and perhaps the number of shares traded (100 shares, for example).

The requirements to be listed or traded on the NYSE are stricter than what are needed to be listed on NASDAQ or AMEX. By requirements we refer to minimum standards of revenues and profits of the firm, and its total capital, which is the amount of a firm's debt and equity. Berkshire first listed on NASDAQ but eventually moved its listing to the NYSE. NASDAQ used to be known as an over-the-counter (OTC) market since, before computers became widespread, its trades were literally entered over the counter at a brokerage office.

A picture of the Edison Stock Ticker Tape Machine that looks like a big lightbulb that would spit out thin strips of paper.

Figure 5.1 Edison Stock Ticker Machine

Source: H.Zimmer, https://commons.wikimedia.org/wiki/File:Edison_Stock_Telegraph_Ticker.jpg. Licensed under CC BY 3.0

A lot of big technology stocks, such as Apple, Intel, and Microsoft, listed on NASDAQ in the 1970s and 1980s and have chosen to remain there. Since some of the biggest firms in the world are listed on NASDAQ, the distinction isn't that big of a deal anymore. And speaking of computers, there is a relatively new type of stock exchange called an Electronic Communication Network (ECN). If you visit the floor of the NYSE on Wall Street in Manhattan, you will see traders working there. With an ECN, it is mostly a bunch of computer servers doing the work, whose job is to simply match buy and sell orders.

A Sidebar on Stock and Mutual Fund Symbols

Did you ever wonder how a company picks its stock symbol? In some cases, the symbol is similar to what the name sounds like. For example, the stock symbol for the construction equipment firm Caterpillar is, not surprisingly, CAT. If a firm trades on AMEX or NYSE, its ticker symbol usually has 3 letters or less. For example, IBM has the ticker symbol IBM. The financial firm J.P. Morgan Chase, has the symbol (JPM). AT&T has the symbol T. If a firm, like AT&T, has only a single letter for its ticker symbol, it's supposed to be prestigious, like a personalized license plate, or a rock star or rapper wearing a lot of bling. Some firms with a single letter symbol that you may have come across include Citi (C), Macy's (M), and U.S. Steel (X).

If the stock has 4 letters in its ticker symbol, it usually trades on NASDAQ. For example, Apple is AAPL. Intel is INTC. Amazon.com is AMZN. Starbucks is SBUX. There are some rare exceptions. For example, Facebook trades on NASDAQ and has the symbol FB.

A mutual fund is an investment product where a bunch of people pool their money together and have it invested by a fund manager, a person who manages investments for others. The investments may include a bunch of things such as stocks, bonds, and cash. We'll talk about them more throughout this book, but for now, we'll mention that mutual funds have a ticker symbol with 5 letters and the last one ends in X. For example, the ticker symbol for the Fidelity Magellan mutual fund is FMAGX. F is for the parent company, Fidelity Investments. MAG is for the Magellan Fund, and X is because it is a mutual fund.

Dividends

A dividend is cash paid by the company to its stockholders. It's similar to a bond coupon paid to bondholders of a firm. A dividend is a check in the mail so to speak, but the money is usually deposited in your brokerage account, which holds your stocks. Who doesn't like getting a check in the mail? The richest person in modern times (i.e., since the Industrial Revolution) was John D. Rockefeller, an oil industry tycoon. You are probably familiar with a company he founded that still exists today, ExxonMobil. He was worth the equivalent of $340 billion today! That amount even leaves Buffett's net worth in the dust!

Anyway, here is an epic quote from Rockefeller on dividends. “Do you know the only thing that gives me pleasure? It's to see my dividends coming in.” Rockefeller thought dividends were the bomb! To give you some perspective, the average dividend paid in percentage terms for the stock market as a whole in recent years, known as the dividend yield, has been roughly 2%. Thus, if a company had a stock price of $100, it would typically pay a dividend of $2 a year. How often are dividends paid? For most companies, they are paid on a quarterly basis.

There is an exception. Sometimes companies pay a one-time, or non-recurring, dividend, known as a special dividend. Perhaps it was because a company got a one-time windfall such as the sale of a building or business. Or maybe there were special tax reasons that made paying the dividend worthwhile. In any event, the company makes it clear when it's paying a regular or special dividend.

Most companies that pay dividends take the money from their quarterly profits or earnings. If a company misses or cuts its dividend payment, its stock will usually get crushed. The company's management knows this, so sometimes it pays out dividends from its equivalent of a piggy bank, or “rainy day fund,” known as retained earnings. More formally, retained earnings is the sum of the company's profits since it started minus any dividend payments over its history. When the company pays dividends from its retained earnings—or worse, borrows the money to pay its dividends—it's like robbing Peter to pay Paul. It can't continue for too long or else the company will crash and burn, like the Falcons blowing a 25-point lead to the Patriots in Super Bowl 51. Sorry, Falcons fans.

There is a whole group of investors who seek out dividends. They often view the dividends as part of their income and use them to help pay living expenses. Some companies make it especially convenient for these dividend-seeking investors and set up what's called Dividend Reinvestment Programs, or DRIPs for short. These programs usually enable investors who don't need the income to use the dividends to buy more shares of stock in the company. In some cases, they let you buy the stock at a slight discount, such as 5% or less. In almost all cases they let you buy the additional shares without paying transaction costs, such as brokerage commissions or record-keeping fees. The company does this since the DRIP investors are often long-term investors, with their actions resulting in less volatility for the company's stock, a feature3that is attractive from the perspective of the company's management.

The percentage of earnings paid out each year is called the payout ratio. The remaining portion of the earnings is called the plowback, or retention, ratio. For example, if a company had $10 in annual earnings and paid out $4 in annual dividends, its payout ratio would be 40%, and its retention ratio (or plowback ratio) would be 60%. Of course, the sum of the payout ratio and retention ratio must equal 100%.

Payout ratios vary widely by industry. It could be more than 80% for many electric and gas utilities. For most companies, it's less than 50%. A lot of companies don't pay any dividends since they think they can use the money that would be sent out as a dividend to invest in good projects, which will result in even more profits down the road. Facebook would fall into this category as well as Alphabet, whose stock was previously known as Google. Google is now a unit of Alphabet. Here's how Buffett said it in his 1981 letter to Berkshire shareholders:

Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas.

One way of estimating “high profits down the road” is through a financial ratio called return on equity (ROE). It's the profit a firm earns divided by the amount of the firm's equity on its books. We’ll discuss some accounting terms Buffett mentioned in his quote, as well as others, when we get to Chapter 7. So don't worry if you don't have a strong grasp of these concepts yet. Let's summarize Buffett's quote into a Tip.

Berkshire hasn't paid a dividend in many decades, since Buffett believes he can invest the money wisely resulting in even more growth in his firm's stock price than if he paid it out as dividends. And historically he has been right. For example, Berkshire paid $44 billion for the transnational railroad Burlington Northern back in 2009. Since that time Burlington has generated tens of billions of dollars in profits, and Berkshire owns the railroad until the end of time. Clearly it takes a lot of dough to do a deal like that, and if Berkshire paid out a lot of its earnings as dividends, it probably wouldn't have had the cash to do it.

You may be wondering why someone might invest in a company that has no short- to intermediate-term chance of paying dividends. The answer is you hope to sell the stock at a higher price than what you bought it for. When you do make a profit in this way, it's called a capital gain. When the opposite occurs, that is, you sell it for a price lower than what you paid for it, it's called a capital loss. You've taken the L in that case. We've all been there, including Buffett. Nobody bats a thousand in investing. An all-star investor is right roughly 60% of the time. Intense competition makes it hard to make a lot of money quickly and easily.

There's actually a way to make money from a fall in a stock's price. It's called selling short, and we don't recommend it for nearly all investors because it's riskier than a buy-and-hold strategy. Similar to “a don't try this stunt at home” disclaimer you might see on TV. Buffett also advises against selling short, so we're including it as a Tip. Timing when to get in and out of an investment is very difficult. Here's his quote, “We probably had a hundred ideas of things that would be good short sales. Probably 95% of them at least turned out to be, and I don't think we would have made a dime out of it if we had been engaged in the activity. It's too difficult.”

We've included a brief discussion of selling short in the Appendix, in case you wind up as a professional investor and want to learn more about the technique. We know most people don't read appendices, so that gives you yet another reason not to sell short.:-)

Large Cap vs. Small Cap

Analysts often classify stocks by certain characteristics. You can think of it as placing stocks in certain buckets. The main buckets we'll focus on are small cap, large cap, growth, value, domestic, and international. Let's define each of these terms.

In baseball, they make a distinction between the minor leagues and major leagues. With stocks, investors often make a distinction between big and small firms. Recall the term market capitalization, or market cap for short, is the amount of money that represents owning 100% of the company’s stock. It equals the stock price times the number of shares outstanding. Companies with a market cap of less than $1 billion are often characterized as small cap, a term we briefly touched upon in Chapter 2. Firms with a market cap of at least $1 billion are considered large cap. It's a big category since some firms, such as Microsoft and Apple, are valued at more than a trillion dollars!

In this book, we're going to focus mainly on the distinction between large cap and small cap, but there are finer distinctions in size. Sticking with our baseball analogy, there are different levels of minor leagues, like A, AA, and AAA. Micro cap is a term used for the smallest firms, usually those with a market cap of less than $100 million. And if that's not small enough for you, a company with a market cap of less than $50 million is called a nano cap (which means very small).

Mid cap is a term used for companies with a market cap between 1 and 10 billion dollars. The term mega cap is often used for firms valued at more than $100 billion. Those are the rock stars of the stock market. Most investors know their names: Microsoft, Disney, Amazon.com, Berkshire, and the like. We're going to cover some of these firms in more detail in Chapter 9.

Growth vs. Value

Another distinction investors make is between growth and value stocks. Value stocks are less expensive relative to some metric, such as the profits they earn each year. They're often beaten down in price. Not much is expected of these firms. Growth stocks are usually growing quickly and are more expensive. They are often emerging all-stars or existing all-stars. Market participants, as a whole, expect big things of these companies, in terms of future rapidly growing sales and earnings. It's usually a case of buying high and expecting to sell higher. For example, it might be a younger version of Amazon.com or even the large and still strongly growing Amazon.com that exists today.

There are many ways to differentiate between growth and value stocks or expensive versus inexpensive. A common approach is to compare their price-to-earnings, or P/E ratios. The P/E ratio for a firm is the market cap of the stock divided by its earnings. Remember, earnings are the same thing as profits and are measured by taking the sales of the firm and then subtracting all of its expenses. The time horizon for this measurement period is typically one year. You get the same P/E ratio if you do this calculation for the entire firm or a single share of its stock.

The companies with the highest P/E ratios (50th percentile or higher) are usually considered to be growth stocks. The companies with the lowest P/E ratios (less than 50th percentile) are considered value stocks. To give you some perspective, historically the P/E of the market as a whole has averaged about 15. Thus, under this barometer, a stock with a P/E less than 15 would be considered a value stock. A stock with a P/E of 15 or higher would be considered a growth stock. In recent years, the P/E for the market has averaged about 16 or 17, so that may be a more accurate cutoff value today.

One important takeaway from this discussion is that the price of a stock alone doesn't tell you if it is expensive or inexpensive. You need to look at the P/E, or other valuation metrics that we'll discuss later. For example, Berkshire Hathaway (Class A) recently sold for about $300,000 for a single share! And because the firm had a P/E less than the market, you could argue the stock is a good value. If you want to blow someone's mind, tell them you know of a stock that costs more than a quarter of a million dollars and that you think it's inexpensive or cheap! Prepare for some blank stares, or worse, but with the knowledge that you're likely correct. This may be a small example of Buffett's Inner Scorecard belief system that we mentioned in Chapter 1.

Many mutual funds have some combination of the words “large,” “small,” “growth,” and “value” in their names, such as the BlackRock Large Cap Value Fund. Investment analysts have coined the term “style box” to explain where they fall on the size and style spectrum. A box has two dimensions. Instead of length and width, we have size and style. The traditional way of showing the style box is in Figure 5.2 for the mutual fund Fidelity Magellan.

Style boxes are well entrenched in Wall Street jargon, but Buffett isn't a fan of the term. He believes growth is really just part of the equation of estimating the value of a stock and that all investors are value oriented since they all want to buy undervalued investments. In his 2000 Letter to Berkshire's Shareholders, Buffett wrote, “Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component—usually a plus, sometimes a minus—in the value equation.”

A traditional way of depicting a style box with two dimensions for the mutual fund Fidelity Magellan.

Figure 5.2 The Style Box

Source: © 2020 Morningstar, Inc. All Rights Reserved. Reproduced with permission.

Domestic vs. International

There are stock markets in most countries around the world. If you invest in companies with their headquarters in your home country (the US in our case) it's called investing domestically. If you invest in companies headquartered outside your home country, it's called investing internationally. If your portfolio or basket of investments consists of both domestic and international stocks, it's called a global portfolio.

Why invest internationally? We can give you several reasons, but it was perhaps said best by Sir John Templeton, an investor who was as famous as Buffett during his day. Sir John said, “If you search worldwide you will find more bargains and better bargains than by searching one nation.”

Buffett invests mostly in the US but has made some international investments. For example, in 2013 Berkshire purchased the Israeli-based tool company Iscar for $2.05 billion. He also invested in a large Chinese oil firm called PetroChina at one point and still maintains a position in the Chinese auto firm BYD.

An Index Fund: A Great “Set It and Forget It” Long-Run Investment

All right. Now that you have some basic fluency concerning the stock market, let's get to the topic of investing in stocks. The first type of investment is simple, but surprisingly effective, and called an index fund. You've probably heard of the Dow Jones Industrial Average (DJIA). That's an index of 30 of the leading, or “blue chip,” stocks headquartered in the US. We'll cover “The Dow” further in Chapter 9. An index fund tries to track the performance of a specific index, such as the DJIA. It's something that's investible, as opposed to being theoretical or conceptual.

You've probably heard of the term blue chip in the context of sports. It means the athlete is almost “can't miss” in terms of being a star. Like Zion Williamson coming out of Duke University or Tiger Woods shortly after he started college. Not all blue-chip athletes pan out, and neither do all stocks with the blue-chip label, at least on a forward-looking basis.

An index with only 30 stocks is kind of narrow. After all, not every athlete or stock can be considered a blue chip. Perhaps the most widely followed index in the US is the Standard and Poor's 500 (S&P 500). We came across the S&P name in Chapter 4 in the context of bond ratings, such as AAA, AA, and so forth. The S&P 500 consists of 500 large cap stocks headquartered in the US. There's an index called the Wilshire 5000, which tries to measure the performance of all publicly traded stocks in the US. When the index was first created, it had about 5,000 stocks in it. Today the number is closer to 4,000.

Sometimes stocks leave an index because they get taken over and no longer trade independently. In other cases, they go out of business or are bankrupt. In that case, their values are virtually zero and wouldn't register on the index.

Buying a diversified stock index fund, such as the S&P 500, is basically a bet on the (American) economy. Over long periods of time, if the economy does well, the index should do well. And Buffett has said something similar many times. For example, in his 2013 Letter to Berkshire Shareholders he wrote, “The 21st century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners—neither he nor his ‘helpers’ can do that—but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.” He said it more succinctly in another of his writings, “A low-cost fund is the most sensible equity investment for the great majority of investors.” That's a good Tip to remember.

Of course, there are index funds available on pretty much every stock market around the world.

We mentioned that index funds perform surprisingly well over the long term (e.g., 10+ years). What is surprisingly well? How about that this simple buy-and-hold strategy that requires minimal effort beats about 90% of active managers over the long term. Say what? Ninety percent? How can this be possible? There are two main reasons: low costs and competition.

Buying an index fund usually isn't free, but its cost is extremely low. The typical cost of an index fund is a tiny fraction of 1% per year, something like 0.1% or 0.2%. With low numbers, such as fractions of 1 percent, analysts often use some other terms. One percent equals 100 basis points. So, 1/10 of 1% equals 10 basis points. Let's tie those numbers to an example. Let's say you invest $1,000 in an index fund on the S&P 500. Your fee would be about $1 a year. Not bad for an investment that historically rises about 10% a year, or $100 in our sample investment. In contrast, if you pay to have someone manage your money, they typically charge you more, often more than 100 basis points a year.

Beating the Market and the Efficient Market Hypothesis

Now let's look at our second reason why it's extremely hard to produce returns higher than a market index, or what's usually called “beating the market” in the financial press. We're not saying it can't be done. Obviously, Buffett has done it over many decades, and we're going to sketch out his approach in the next chapter. We're just giving you the argument why an index fund approach may make sense for the vast majority of investors.

We mentioned intense competition as the second reason why it's difficult to consistently beat the market. We'll provide a bit more detail and start our explanation with a story. There's a story in the most popular college investments textbook that goes something like this.

Two college professors are walking down the street, and there appears to be a $20 bill lying in the middle of the street. Let's say the first professor teaches finance, and the second professor teaches history. The finance professor walks by the $20 bill, and the history professor stoops down to pick it up and says, “Why didn't you try to pick up the money on the ground?” The finance professor replies, “Well, if it was real, someone would have picked it up beforehand.”

Not funny? Well, you can't expect too much in the way of comedy from a textbook. :-) The moral of the story is that investors aren't going to leave free money on the ground. When they see it, they pick it up very quickly. When important information comes out about a stock, such as its earnings report, a merger, new product, and so forth, investors interpret this information very quickly. If the news is good and better than what is expected, the stock will quickly go up. If the news is bad and worse than expected, the stock will quickly go down. For example, when it became apparent that the COVID-19 pandemic would shut down entire segments of the economy, stock prices quickly plummeted about 30%!

A market that quickly and appropriately reacts to information is called efficient. Sometimes it goes by its theoretical name, the Efficient Market Hypothesis (EMH). The financial press often uses another name—the Random Walk Hypothesis. This latter term has a colorful history. One story says the name is derived from a drunk person looking for his keys that fell on the ground at night. He'd take a step in one direction and then another and then another and wind up where he started, without the keys!

Since there will always be intense competition on Wall Street and new information is usually quickly reflected in stock prices, it's mainly new information or news that moves stock prices. Almost by definition, new information is virtually impossible to predict; therefore, most investors have no advantage versus a simple buy-and-hold index fund strategy.

If your mind is spinning from the Random Walk Hypothesis, we have a cool way of thinking about this concept that is easy to understand. If the market is always efficient, you could throw darts at the stock pages of The Wall Street Journal and a basket of the stocks that were hit with the darts would, on average, perform about the same as the market or a portfolio picked by a professional investor!

Meet Mr. Market, the Manic-Depressive Stock Market

But there is a glimmer of hope for those who want to engage in active stock selection in order to try to beat the market. Buffett said that some expert investors, or those who study to become experts, have a chance of beating the market. He criticized academics who say the market is always efficient. In his 1988 Letter to Berkshire Shareholders he wrote, “Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.” Let's spin that quote into a Tip.

Benjamin Graham used a widely cited analogy to explain how the stock market works. He said imagine being in business with a manic-depressive business partner by the name of Mr. Market. Sometimes he's extremely happy and generous and offers you a great price for your share of the business, if you want to sell. Other times he is extremely depressed and offers you a very low price for your share of the business, also in the event that you want to sell.

In other cases, he'd offer you a fair price for your share of the business if, yet again, you want to sell. In this latter case, you can view the market as being efficient. Graham's point is don't try to change Mr. Market's mind since it can't be done. Just try to take advantage of his irrational behavior, by buying (low) when he is depressed and by selling (high) when he is euphoric.

You might be wondering what causes Mr. Market, or the market as a whole, to be occasionally out of whack. Well, it basically boils down to two words about human nature that have been around since the beginning of time: fear and greed.

Benjamin Graham had another analogy to describe the market that uses a pendulum instead of a moody business partner. He said, “The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The Intelligent Investor is a realist who sells to optimists and buys from pessimists.” Buffett said it more succinctly when he wrote in his 1986 letter to shareholders, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” We mentioned this quote back in Chapter 1. It's one of his most famous sayings, so let's put it as an official Tip here.

When prices get really out of whack, it's called a bubble—similar to blowing a bubble with a piece of bubble gum. It slowly inflates, due to hope, excitement, and, eventually, greed. At some point more rational thinking prevails, and then the bubble pops, driven by fear. There have been many investment bubbles throughout history. Not only with stocks but with all kinds of things. One of the most famous bubbles occurred in Holland during the late 1630s with, of all things, tulips. Yes, we mean the pretty-looking flowers. We'll skip the details, but during the peak of “Tulip mania,” in around 1637, the price of a single prized tulip sold for the equivalent of four tons of beer, two tons of butter, one thousand pounds of cheese, four fat oxen, eight fat swine, twelve fat sheep, four lasts of rye, two hogsheads of wine, a complete bed, a suit of clothes, and a silver drinking-cup! Or for the price of a house in many parts of America.

Buffett, and most rational investors, know that bubbles can't last forever. In his 2000 Letter to Berkshire Shareholders he wrote, “But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street—a community in which quality control is not prized—will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.” Let's include the key lesson as a Tip.

You might think only fools or ignorant people get caught up in bubbles. On the contrary, Buffett wrote about one of the smartest people who ever lived, Sir Isaac Newton, getting caught up in a bubble related to a stock called the South Sea Company. Sir Isaac lost roughly the equivalent of $4 million today. Buffett wrote in his 1993 Letter to Berkshire Shareholders, “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.” In other words, don't try to chase the latest hot thing when a frenzy or bubble is building up around an investment. Be patient, and always look for value.

Appendix

You've probably heard the expression “Buy low and sell high.” It's the way most investors try to make money. For example, you might buy a stock for $10 a share and hope to sell it sometime down the road for $20. This traditional way of investing is called buying long.

As we mentioned in the main body of this chapter, there's a way of profiting from a drop in a stock's price. It's called selling short. The emphasis is on the word short to differentiate it from plain old selling. The traditional order is first buying a stock and then selling, when you are ready to close out the investment. For example, you may buy a stock at $15 and hopefully sell it at a higher price—let's say $20 a share—for a profit of $5 a share.

With selling short you first sell and then buy back later, hopefully at a lower price. You have no position in the stock prior to the short sale. For example, if you sell short a stock at $20 and later buy it back for $15, you've made a profit of $5. Once again, notice the order of selling first and buying back later, as well as the $5 positive profit earned after the stock dropped from $20 to $15.

We're sure you're thinking, “How can you sell something that you don't own?” The answer is that the stock is borrowed from another investor at the firm. This other investor is usually clueless as to what is going on. As far as they are concerned, they still own the stock. And they do from a legal perspective. But the information technology system of the brokerage firm keeps track of everything behind the scenes.

Instead of borrowing a pencil, ruler, or calculator from someone, you've borrowed a stock. And just like with a physical good, you can get in trouble if you don't return something that you borrowed. In this case you've made a promise to buy the same amount of shares that you borrowed, at some point in the future.

Another question you may have is, “When does the short seller have to buy back the stock and return the borrowed shares?” The answer is slightly complicated. Here goes. If there are a lot of shares available for borrowing, then you can keep your short position open for many years—almost indefinitely. However, if a lot of investors are trying to short the company, shares to borrow might be in tight supply. In that case, the brokerage firm may force you to buy back shares from the market even if you are not ready. When the broker forces you to return the shares when you're not ready, it's called a short squeeze. The brokerage firm maintains a list of hard-to-borrow stocks each day. These are the stocks that are susceptible to being the subject of a short squeeze, providing the short seller with at least some warning.

So why do most people recommend not selling short? First, the stock market usually goes up over long periods of time. Historically it has risen about 10% a year. Therefore, by selling short you are basically swimming against the tide since you are betting a stock is going to fall in price while the general tide of the market is to rise in price. Second, if a stock pays dividends, the short seller is obligated to pay the dividends to the original lender of the shares. Third, small investors may have to pay extra money, in the form of interest to the brokerage firm, in order to get the shares. And last but not least, your risk of loss on the downside is virtually unlimited.

For example, if you sell a stock short at $10 and it goes to zero you've made $10. But what if the stock goes up in value, to say $50 a share. Here you've lost $40 a share (bought at $50 and sold at $10). Imagine if someone sold Berkshire Hathaway short when Buffett took over the company and somehow they were able to maintain their position through the end of 2019. A $1,000 short sale investment would have resulted in a loss of more than $20 million!

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