Afford Anything - Why Does the Stock Market Crash? | Stocks 101 Explained, with Brian Feroldi

Episode Date: March 9, 2022

#369: To answer these questions, we need a deep, tree-trunk understanding – a core, fundamental understanding – of how the stock market operates. What, exactly, IS a stock – and how are stocks valued? What’s the difference between the Dow Jones, the S&P 500, and the Nasdaq? Why is the market a voting machine in the short-term, but a weighing machine in the long-term? Brian Feroldi, the author of “Why Does the Stock Market Go Up?,” joins us for a Stocks 101 explainer episode. If you’d like a deeper understanding of the world of stocks, you’ll enjoy this explainer episode. And if you have a friend/spouse/coworker who’s said, “I need to learn more about investing,” share this episode with them. Enjoy! For more information, visit the show notes at https://affordanything.com/episode369 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, just not everything. Every choice that you make is a trade-off against something else. And that doesn't just apply to your money. That applies to your time, your focus, your energy, your attention, to any limited resource that you need to manage. Saying yes to something implicitly means turning away all other opportunities. And that opens up two questions. First, who do you want to be?

What matters most? What do you value? And that's a very different question than what? What is the shiny distraction in front of you? That's the first question. The second, follow-up question to that is once you identify those values, how do you put that into practice? How do you align your decision-making to reflect that which matters most?

Answering those two questions and doing it well is a lifetime practice. And that's what this podcast is here to explore and facilitate. My name is Paula Pan. I am the host of the Afford Anything podcast. And today, Brian Faraldi joins us for a super comprehensive explainer episode about stocks and the stock market. Why does the stock market go up? Why does the stock market crash? What the heck is a stock?

If you or someone you know, a spouse, a sibling, a friend, has always been a little flummoxed by the world of stocks and investing, this is your Stocks 101. one explainer episode. If you find stock market jargon confusing, or if you worry that stock investing is too technical, this is the episode that will start demystifying the process. We cover what is a stock? Why do stocks have value? What's the stock market? What's the Dow Jones? What's the S&P 500? What's the NASDAQ? Why do companies go public? How are stocks valued? What's a PE ratio? And what causes that to change? Why do stocks fluctuate? Why do they have share prices that go? up and down every day? And why does the market as a whole go up and down every day? And what does that mean for their long-term performance? What causes the market to crash? What causes it to rise?

And why? At a fundamental level, why is it that the stock market has always, historically, always recovered from crashes? We know that that's true, but why? We're going to cover all of that in today's Stock Explaner episode. Brian Faraldi is the author of the book Why does the stock market go up? Where he deep dives into that question, because we know that stocks are great long-term investments. We've heard the stats that the U.S. stock market goes up over a long-term annualized aggregate average around roughly 10% per year, 8 to 10% per year over the long term. We've heard people talk about the fact that the market crashes occasionally, but it always recovers. But why? Why has the market? gone up for 150 years? Why does it continually set record highs? Once we have a solid tree-trunk understanding of the stock market, we can answer that question. And once we answer that question, we can invest with confidence. So why does the market go up? Why does it crash? Why does it recover? To answer those questions, here is Brian Farrelldi. Hey, Brian. Hey, Paula. How's it going? It's going

great. How are you doing? I am great. And I want to kick off our conversation with the literally million dollar question, billion dollar question, really. Why does the stock market crash? Tell us. Maybe even the trillion dollar question, Paula. Yeah, it is. Yeah, I'm sure. Yeah. It's a multi-billion, if not trillion dollar question. And that's a particularly timely question to ask, because as we're speaking about, the U.S. stock markets are in a bare market or pretty darn close to a bare market, which is defined as a drop of 20% roughly from their recent highs. And if you look back at history, the stock market has crashed numerous times. Now, to understand why the stock market crashes, you really have to understand what

stock prices really represent at any given time. Whenever you see a stock price, this could be an individual company or the markets in general. What that's reflecting in a minute-by-minute basis is two things. One is the earnings power, the profits of the underlying businesses that represent either that individual stock or the stock market as a whole. And two, how investors feel about the future of that company or company's profits. That's what prices represent.

Now, if you break those two down, the current earnings are a very, very small part of the current price of a stock. And the expectation, or how investors feel about the price. of those stocks are a large component of the price at any given time. So when stock prices are changing rapidly, typically falling or crashing, what that represents is a broad-based feeling that the profits or the way that investors are valuing those profits of those companies takes a sudden and dramatic turn for the worse. And that leads to fear, and that fear causes investors to fear that prices investors to fear that

prices are going to fall. Investors get into the market and sell their stock. That causes other investors to become fearful that prices are going to fall. That causes even more selling pressure. And what happens is the stock market crashes. And again, if you look back at history, stock market crashes have happened several times in my lifetime. I mean, there was the COVID crash of February 2020. There was the great recession of 2008. There was the dot-com crash of 2002. And there was even Black Monday, which is when the market indices fell essentially 30% over the matter of a month in 1987. And these are just common features of markets, but they always represent investors' emotions, broadly based, suddenly turning negative. Okay. I'd like to dig into that. But before we get there, let's take a step back and establish a couple of basics.

And you've touched on this a little bit, but can you explain at a fundamental level, what is a stock? Yeah, this is something that really confused me. And it's so funny that term stock and stock market is thrown around and people just assume that you know what that is. But it really does pay off to go back to a fundamental level of determining what they are. So, Paul, let's just say that you and I are going to start a business together. Really simple business. We're going to start selling candy. Now, this business, we estimate, is going to cost us $50,000 to get off the ground. Now, I don't have that much money to invest in this business. I only have $10,000.

You, Miss Moneybags, have $40,000 to put up in this business. So you put in $40,000. I put in $10,000. There's our $50,000 to get this candy business off the ground. Now, this business, let's say that it's profitable and it goes on to become successful and make a profit. When those profits are going to be distributed to the owners, how do we figure out how much goes to you and how much goes to me. Well, that's why stocks and shares were invented.

The stocks in a real estate represent fractional ownership of a corporation. There are an accounting tool for figuring out how much of a corporation each of the individual shareholders own. Now, in our case, our business is very simple to figure out, right? You own 80%, you put in $40,000 of the $50,000. I own 20%. I put in $10,000 of the $50,000. So you own 80%, I own 20%. Well, you can imagine how it can get complex very quickly if you have more than one investor putting money in. And if we put in at different times, so to simplify that, corporations break up their ownership of their companies into individual shares, and each of those shares represents fractional ownership of the corporation. Now, what's interesting is you can have as many shares as you want in a company.

It's actually a totally made up number. So to make things easy, let's just say that our corporation has 50,000 shares. Again, we can make it 500,000, we can make it $500,000, whatever we want. But for simplicity, we're going to make it 50,000 shares. All right. So you put in, there is 50,000 shares in total, $50,000 in total. Every share we determine is worth $1. You have 40,000 shares.

I have 10,000 shares. That's what stocks are. They're a way to make record keeping for who owns how much of a corporation easy. Excellent. Earlier you talked about how the share price of a stock is determined in part by earnings and in part by emotion. Can you talk about the calculation of a share price of a stock with regard to its earnings? So let's break that down a little further. So at any given time, a stock is valued based on essentially two things. One is the earnings or the price. of that business. And the other thing is how investors value or how much investors are willing to pay for the earnings of that business. A very common metric that investors use to figure out that

second part is called the price to earnings ratio. That's also called the PE ratio. And what this represents is the, it's a ratio between the price of a company or the price of one share of a stock divided by the earnings of that company on a per share basis. So a real simple example, Apple is one of the largest companies in the world. And Apple is currently trading at $166 per share as we speak. Now, if you look at the earnings of Apple, last year, Apple's earnings were about $5.61. So $5.61 per share. Per share. Exactly. So if we do some quick math on that, $166 divided by $5.61, Apple's stock is currently trading at a P.E ratio of 29. So for every dollar in earnings,

investors are currently willing to value Apple at 29 times that number. So that 29 P.E. ratio represents the future value of Apple stock that investors are currently willing to pay for it. Why is it that in different industries, you'll often see wildly different PE ratios? So for example, you'll see incredibly different common PE ratios in the utility sector versus the tech sector. Yeah, this is one of the trickiest things about investing when you really dig into it at an individual company. So the PE ratio is a very commonly used valuation tool for figuring out at.

as you said, how much investors are paying for one company versus another. It makes an easy comparison between them. However, there's a variety of reasons that investors are willing to pay a higher P.E. ratio for one company than they are to pay for another company. So let's just compare, like you just said, utility compared to Apple. Typically speaking, utilities are very stable, but very, very slow growing businesses. They operate in a geography. They have a monopoly.

prices that they can charge are actually regulated by the government. So their earnings tend to be extremely predictable. However, they only grow a few percent per year because they're limited with how much they can charge their customers and their pricing is set by the government. For that reason, investors don't have a lot of optimism in utilities to substantially grow their earnings over periods of time. For that reason, they tend to value the earnings power of utility at a lower rate than they would for. for a high growth company like a Microsoft or an Apple. So in Apple's case, their price to earnings ratio is 29. That's actually higher than the price to earnings ratio of the S&P 500 broadly.

So that's investors way of saying that they think that Apple is either, one, a higher quality business than the average company in the S&P 500, or it's going to grow faster than the average company in the S&P 500 or both. Speaking of the S&P 500, can you talk about the makeup, the constitution of these major indices, the S&P 500, the Dow Jones, the NASDAQ? Let's start with the fundamental question. And this is an episode. It's an explainer episode for people who are not acquainted with the role of stocks. We'll start with the fundamental question of what is an index or an indecy and how were these formed. Well, let's start with like what is an index? Specifically, what's go to one of the first indices that was created, the Dow's. Jones Industrial Average. That's a term that everybody listening has heard or come in contact with at some point. But I know that before somebody explained what it was to me, I had no idea what it was.

So let's rewind the clock to the 1890s. So many, many, many years ago. Back then, there were publicly traded companies in New York specifically. Now, the newspaper at the time, which eventually became the Wall Street. Journal reported the prices of stocks every single day. And the editor of the Wall Street Journal, his name was Charles Dow. And he was printing these stock prices every day. But there was no way that he could look at these stock prices, which were just tables of moving prices, and kind of summarize what happened in the market that day. Some stocks went up, some stocks went down.

But there wasn't a handy way that he could summarize for his readers what was going on. in the markets. So his business partner, Edward Jones and Charles Dow, invented a solution. What they did was they added up the stock prices of 10 of the biggest publicly traded companies at the time. So they added up the stock prices. And then they divided the total by the number of companies that they added up. Now, there's a math term for that. That's called averaging when you add up a whole bunch and then you divide by the total. And at the time, most of the biggest companies that traded in the public exchanges were industrial companies. So chemical companies, railroad companies, big, huge companies. So they called this invention the Dow Jones Industrial Average, and they started to

report this number every day starting in 1896. And finally, they could take a small sample of stocks and they could use that to represent to their readers what happened in the stock market that day. Now, that idea caught on with investors and the Dow went on to become one of the most widely known market indices in the world, but that's what a market indices is. It's when a grouping of stocks, their price changes on any given day are collaborated together to report to give investors an idea of what happened with that market. Now, the Dow evolved over time. It gradually added more companies, and today it actually holds 30 companies in it.

And like any capitalist society, another company called Standard & Poor's looked at what Dow Jones was doing and said, hey, we want to make our own indices. We want to get our own name out there. So they went on to create what would become the Standard and Poor's 500, S&P 500. So rather than using 30 stocks like the Dow did, they used $5.5. 500 stocks. And it was much easier when the S&P 500 was created in the 1950s to do this because computers could start to do the math. Previously, it was all done by hand. And then in 1971, a brand new stock market index called the NASDAQ or the National Association of Security Dealers automated quotations. That's what NASDAQ stand for. A brand new stock index was created,

a stock exchange. And this was 100% electronic. So the trading wasn't done. in person with physical papers, it was done electronically. Well, this new stock exchange wanted to create its own stock market index, and they created the NASDAQ composite. So that's why today we have these three major stock market indices, the Dow Jones Industrial Average, which has 30 companies, the S&P 500, which has 500 companies, and the NASDAQ composite, which has over 3,000 companies in there. But when you see these numbers reported in the newspaper or are on the news, what they're showing you is how much the stock prices of their individual holdings moved on average on that particular day.

And so with something like the Dow Jones, one of the criticisms of it could be that it, by definition, overweights to large-cap stocks since it's only representing some of the biggest movers. And so something like the S&P 500 or the NASDAQ, which represent a larger basket, are arguably more representative of the market as a whole. That being said, the largest companies are the biggest movers. And what happens with those largest companies has an outsized impact on the market as a whole. So for that reason, it's good to take in all of the available data.

Yeah, you are 100% correct. The Dow Jones, while it is the oldest and known that we have data that goes back the longest on, it does have its critics. To your point, it only tracks 30 companies. So 30 companies represent the stock market as a lot. whole, and there are literally thousands of publicly traded companies out there. So does 30 companies really measure what's happening in the market the whole? Another limitation of the Dow Jones Industrial average is that it uses the price of one share to figure out how much the index moved.

Now, that can be a big problem because the price of one share doesn't necessarily indicate how big or how important a company is. but because the Dow was created more than 100 years ago, they needed an easy way to do this math. So using the share price was the quickest and easiest way to do it. So that is one thing that the S&P 500 fixes. Rather than using the price of a single share, the S&P 500 weighs the index by how big the company is, and that's using a metric called the market capitalization. So the larger a company is in terms of size, the bigger influence it has over the index

and the smaller is the inverse. So that is a couple of the differences between them. But what's remarkable is that these three indices, while they do differ on the technical level, their prices have largely moved in lockstep with each other since each of them were created. You've talked a bit about investor sentiment, enthusiasm and or fear. What influences investor sentiment and what other factors influence stocks as a whole to go up or down? Well, there's a whole bunch of things that influence the near-term, the near-term

price movements of stocks. I mean, stocks trade based on the enthusiasm and the excitement of the investor community at large. And we're social creatures and we take our cues from other people and the herd mentality is a real thing. There are long periods of time when investors are extremely excited to be buying stock. They're extremely bullish or optimistic about the future prosperity of American businesses, and they are willing to pay higher and higher prices to own stocks. We saw exactly that thing happen to many, many growth stocks in 2020, for example. So many stocks that benefited from the massive changes that were going away, such as Zoom and Teledoc and Peloton, their stock prices took off in 2020 because investors were so enthusiastic about those

companies near-term growth prospects. But the bad thing is that exact process. can happen in reverse. If investors as a group suddenly turn bearish or fearful about stock and stock prices, they can sell off those stocks, which causes the price to go down. And when prices are going down, that fills a lot of investors with fear that the prices are going to continue going down. And again, we take our cues from each other. The best quote I've ever heard on what happens to stock prices in the short and long term comes from Benjamin Graham, who is one of Warren Buffett's Mentor, he says, in the short term, the market is a voting machine.

But in the long term, the market is a weighing machine. What that means is that in the short term, stock prices move up and down based on the emotions of market participants, broadly speaking. However, over a long period of time, what moves stock prices is the underlying economic earnings power of the companies that are in that next, i.e., how profitable are those companies and what direction do those companies profits head in? We'll come back to the show in just a second, but first... Fifth Third Bank's commercial payments are fast and efficient, but they're not just fast and efficient. They're also powered by the latest in-payments technology, built to evolve with your business.

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How does growth impact a company's value? So if a company is profitable and it continues to become increasingly profitable over time, time, what effect does that have? Well, I think the simple way to explain that is to go back to our candy shop example, Paul. So again, me and you are running this candy shop. We initially put in $50,000 in total. You own 80% of it. I own 20% of it and we start selling candy. Well, let's just say that in our first year, we're fabulously successful. Okay, our business generates $100,000 in profits in its first year. And we want to take that $100,000 and reward ourselves for starting our new business. Well, how much of that profit goes to you? Well, the answer is 80%. So you would get $80,000 paid to you,

and I would get $20,000 paid to me. So our candy business is a huge success. So would you want to own, if you didn't own, if you didn't start this company with us, would you want to be an owner of this candy business? Well, I hope the answer is yes. I mean, in the first year, we just made a profit of $100,000. So you should be willing, you should desire owning our stock because that stock provided us with an income from operating that business. Well, how much would you pay? Well, that's up for debate, depending on how optimistic you were about the future potential of our business and how optimistic we were as owners. But pretend for a second that we operated this business for 10 years. We did so successful, and every year our business became more and more and more profitable. So much so that by year 10,

we were doing $1 million in profits per year. And again, of that, 80% was paid out to you, $800,000 and 20% or $200,000 was paid back to me. In that scenario, would you be willing to pay more for our business 10 years from now than you would today? Well, I hope the answer is yes. the profits of our business just went up by a factor of 10 over that period. So by the same analogy, the value of our business should grow in lockstep with the growth of our profits over that period of time. By and large, the more profits or the higher profits of a business go, the more the business is worth. So therefore, the higher the stock price of that companies should go over time. Why is it then that stable blue chip companies often tend to be the largest? They,

tend to have been the ones that have been around for a long time. They've proven their longevity. They've had a lot of growth. And yet, they don't see a lot of volatility in their stock price. Well, like anything, you have to look at the individual. It really comes down to what individual company you are talking about. We've seen very large companies such as Apple and Microsoft do very, very well for long periods of time. And while their stocks have remained volatile, their investors have been hugely rewarded for owning their stocks. Conversely, if you go back and look at a large company such as General Electric, General Electric was once the bluest of the blue chips, the bedrock of the American economy. No company was bigger, more stable, more dependable. However, if you look

at what happens to GE stock over the last 20 years, it's been a train wreck. I mean, there's no other way to say it. GE stock price peaked at over $440 in July of 2000, it's currently about $90. So that's a 20 plus year period where the owners of that stock have seen the value of their holdings decline by 75% by and large. And what caused that? Well, the underlying economic earning power of GE has come into question. They made some bad bets on areas of the economy that did not pay off. And they were just a huge conglomeration of a business that has have been unwound over the last 20 years. So by and large, the volatility of a stock is a reflection of the underlying earnings power of the company. And large companies tend to be less volatile than

smaller companies. But like anything, we live in a capitalist society and nothing is forever. And it's really about the long-term direction of the business that the stock will ultimately follow. And so investor sentiment about not simply how the company has performed, but also the direction of its growth and its prospects for the future. Will the next 10 years be as good as the last 10? Exactly. That's a huge part of the price of a stock at any given time. It's not only what has a stock done previously looking backwards, but a big part of stock prices is what the company expected to do moving forward. That optimism or pessimism is always reflected in the current price of that stock. Investors as an aggregate seem to be rather optimistic because the stock market as a whole

tends to go up. Can you talk about how often the market goes up? Yeah, I will tell you, when I first started investing, one of the things that I'd always heard about the stock market was, yes, it was volatile, but the returns that the stock market provides investors are about 10% per year. And as a potential investor myself, I was like, well, that sounds great. But whenever I looked at a stock chart, all as I saw was a squiggly line going up and down. And I was like, where is this magical 10% per year that I'm promised as an investor. But if you look at the returns of the stock market over long periods of time, so measured over a decade time periods, not one year time periods,

that is the average return that investors have gotten over long periods of time. And we should also point out that that return comes in two primary format. The first way and the way that most people think that they earn a return from a stock is by the share price moving up. And the share price of the major indices does tend to move up. over time. That's one way that investors earn a return. The second way that they earn a return is by pulling in the dividends from the stock that they own. And if you look historically, the dividend has provided a return of about 2 to 3 percent per year. So the stock prices go up about 6 to 7

percent per year. The dividends are about 2 to 3 percent per year. That's where you get that magical 10 percent return per year on. However, those returns are extremely, extremely lumpy. There are multi-year periods sometimes where stocks do nothing but stay flat or even go down. There are also single-year periods where the entire market goes up 30, 40, or 50 percent. So when you're looking at the returns of the market, it's really important to zoom out and judge the market by the appropriate time period, which is measured in decades. Now, the good news is if you look at the long-term returns of the market and measure over the appropriate time period, the returns are actually pretty darn consistent. There's a wonderful

study that I saw where they looked at if you bought the S&P 500 and held it for various periods of time, what was the odd that you earned a positive real return on your money? So real return, meaning after accounting for the effects of inflation. And what the study found is, if you buy this S&P 500 and hold it for one month, your odds of making money are about 60%. 60% of the time, you'll have a positive return. Well, if you stretch that out to one year, so you buy an S&P 500 and hold for a year, the odds of you making money go up to 69%. If you hold for five years, it's an 81% chance.

10 years, it's an 89% chance. And if you buy and hold the S&P 500 for 20 years, you have made money in real terms 100% of the time. Said differently, there's never been a 20-year period. period in U.S. stock market history, and that includes world wars, presidential assassinations, pandemics, economic shots, depression, etc., where you lost money if you bought and held it for 20 years. And so on that note, let's talk about the converse. What causes the stock market to crash? Occasionally, those crashes, while they differ in severity and duration, occasionally those crashes result in a market that stays low for an uncomfortably long period of time,

such as the Great Recession of 2007, 2008. Yeah, I've spent a lot of time looking and thinking about stock market crashes. And if you're going to invest, this is something that is inevitably going to be put onto your plate. In fact, I think that good investing is really about 90% mentally and emotionally preparing yourself to see a huge amount of wealth disappear in a short period of time. because if you invest in the markets, that's going to happen. And how you act and how you behave in those times is going to determine almost everything about how your long-term results set out.

So to your point, what is the source of the stock market crashes? There's been a variety of things. There's usually something growing on in the macro environment that causes the stock market to crash. Historically, that was caused by the Great Depression in 1929, the Bay of Pigs crisis slash the Cuban Missile Crisis in 1961. There was the oil embargo and Watergate in 1973. There was huge inflation and high interest rates in the 1980s. There was the dot-com crash in the 2000s. There was a great recession in 2007, etc. In each of those cases, peak to trough, the market swooned by a huge

percentage. In World War II, it fell 30%. In Watergate embargo, it felt 48%. In a dot-com crash, it fell 59% and in the Great Depression it fell 86%. And in each of those cases, the time and that it took investors to get back to hole was measured in a period of months or in even years. So that is just a feature of the market. If you invest for any amount of time, you can be 100% sure that you will face a severe stock market crash for a cause that is really unknown and unknowable ahead of time. However, as long as the underlying businesses that make up those indices recover and eventually go on to produce record profits, which has happened every single time this has happened, you can be sure that stock prices will eventually recover from their lows and eventually go on to make new highs. Let's dive deeper. Why is that?

Why does the stock market always recover from crashes? Again, this is something that really confused me when I was a new investor. I mean, I remember watching the stock market when I was in college during the 2001 terrorist attacks and the dot-com explosion and just seeing the stock market go down, down, down. And I remember feeling like, well, that's it. Capitalism had a really good run, but it's over now. And what happened will the stock market eventually bottomed? And then it eventually went on to reach a new high. And then I saw the great recession, which was terrible economic times, right?

Unemployment rate skyrocketed. Businesses were going under everywhere. housing prices were falling. It was awful. And the stock market crashed again. And I thought, well, okay, well, that's it. Right. How are we going to recover from this? And what happened within a few years, stock prices had fully recovered. And then they went on to reach new all-time highs. And then COVID happened and repeat what I just said over and over again. And I was like, why does the stock market always recover? And the question you really need to get into is, why do the businesses that comprise the stock market, why do their profits eventually recover from the tough times that they face?

And there's a couple of reasons for that. First and foremost, whenever there's an economic shock or tough times come, innovation actually goes up. During periods of economic shock, companies are forced to try new things that they wouldn't have tried before. I mean, look at COVID. How many companies allowed for remote work prior to COVID versus? is how many offer remote work now. It is night and day. And why is that? Not because they wanted to, because they had to. They were going through these extremely tough times and companies were just forced to adapt to really a major threat to their businesses. So that's the thing with one. During economic downturns, people are laid off and they innovate. They create new ideas. They launch new products.

They start new businesses. And that really sets the stage for future growth. So that's thing one, bad times, eventually set the stage for good times. Two, weak businesses, the weakest businesses in industries can't survive economic shocks as well as their stronger counterparts can. So that means that those weak businesses die, they fold up, or they get bought out by stronger businesses. So market share tends to consolidate. When that happens, the businesses that can survive, that can survive the economic

downtimes, they gain market share. They pick up customers. They acquire their competitors on the cheap. So while they go through a temporary downturn, they actually emerge stronger on the other end and their profit potential actually goes up. Number three, government. The government usually steps in when it sees market chaos and provides assistance. And that could be in the form of loans to businesses. In COVID's case, we saw a direct payment to consumers. We saw plenty of government assistance going out there to make the money supply easier. We saw the exact same thing in the Great Recession, and that helps to stimulate economic activity post recovery. But during any of these downturns, what happens is the weakest

businesses go under. The strongest businesses tend to get stronger. The weak businesses tend to be kicked out of the major indices, right? The Dow and the S&P 500, their weak businesses leave. New businesses, new innovative companies come in and take their place, and overall profitability of the underlying companies tends to go up. So because the profits of the underlying businesses tends to not only recover and the businesses emerge stronger, that's one of the reasons why stock markets

have always recovered historically from bad times. It's essentially a cycle where good times eventually lead to excessiveness. Excessiveness leads to bad times. Bad time washes out the excess, and that sets the stage for the next phase of growth. You mentioned innovation. What is innovation and what innovative

companies or new innovations do you see on the horizon? Yeah, I think that the 2020s are going to be one of the most disruptive and innovative periods in history of the United States. It is truly astounding the number of massive technological and innovative shifts that are currently underway in the economy. But let's back up and say, what is innovation? So innovation, broadly speaking, is when new types of goods and services are brought to market. And those goods and services that are new open up new, new, business opportunities for companies. So a real simple one. Rewind the clock to 1990. Smartphones didn't exist, right? What were smartphone sales in 1990? Zero. Okay, fast forward to 2020. In 2020, more than three billion consumers had smartphones and smartphone sales totaled more than

$700 billion. So that's an example of a market that didn't exist 30 years ago and today generates It's more than $700 billion in sales. Now, yes, smartphones have also caused other industries to be wiped out completely. I mean, the number of uses of a smartphone are just so high that some industries don't exist anymore. But by and large, innovation opens up new market opportunities that helps to actually grow and expand the economy. And what's so exciting today is the number of innovations that are out there is just astronomically high. I mean, I'll just lead a couple to you that I'm particularly interested in. 3D printing, artificial intelligence, autonomous vehicles, cloud computing,

cryptocurrencies, desalination, edge computing, electric bikes, electric payments, gene editing, mRNA, nanotechnology, nuclear 2.0, so next generation nuclear, personalized medicine, personalized insurance, next generation plastics, recycling 2.0, robotics, software as a service. that is just a small sample of some of the innovations that are happening in the market right now. Now, I can all but guarantee that many of these innovations that are out there won't come anywhere close to living up their potential, right? There's often a lot of hype around some of these industries that just doesn't go on to live up the potential. But could one of these be essentially the size of the next equal in size to what we've seen from like the internet?

It's certainly possible. And innovation is a key thing that really opens a up new revenue and new profit opportunities for businesses and is one reason why the economy and businesses become more profitable over time. And it also speaks to how in the absence of any type of specialized knowledge as to who the big winners are going to be, investing in the aggregate, meaning investing in the index, is a way to capture the gains from many new companies that are poised to become the winners who the average person you and I cannot predict. Yeah, that's one of the wonderful things about investing in index funds. If you buy a broad-based index fund that captures the S&P 500, you can be nearly assured that

whatever companies emerge that take advantage of whatever trends are going to grow will eventually find their way into the indices and in essence, we'll find their way into your portfolio. So if you don't want to go through the hassle of trying to think through which these technologies will emerge and which companies will win, that's one of the many reasons why investing in index funds is such a great choice. We'll come back to this episode after this word from our sponsors. On the topic of innovation, many new companies start off as private businesses, often funded by VCs, and eventually IPO go public.

Why do they do that? Yeah, if you look at what's happened today, the venture capital industry has essentially gone from nothing to being worth tens or even hundreds of billions of dollars to day, but if you rewind the clock even like 30 years ago, the venture capital industry was essentially nascent. And if you were a company that was growing and taking advantage of any sort of trend, one thing that's very common for companies like that is they need capital. Just think about like in the early days of Amazon.com when Jeff Bezos was founding it. It was a website and think about how much things he needed to invest in in order to make Amazon into what it is today. He needed capital.

to buy the books that he was selling. He needed a warehouse to store them. He needed access to shipping solutions to get it out there. He needed to market his product. He needed to make his website accept payments. So he needed to hire engineers and marketing people and finance people. All of those things cost money. And Jeff Bezos personally did not have the capital needed to get that business off the ground.

So after going through and raising a friends and family around early on, Jeff Bezos decided to take Amazon.com. public in the 1990s. And by doing so, what he did was he created new shares of stocks. Remember those shares that we were talked about before? One thing that you can do when you are a corporation is create new shares of stock at will so that you can accept new investors. This is something companies do all the time when they go public. So Jeff Bezos and Amazon needed money. So they created new shares of Amazon.com and sold those on the public exchange. In exchange, in exchange, for doing so, Amazon got a big one-time cash payment from the public investors that were now investing in the company, and Amazon could use that capital in order to fund its continued growth

and continued development. So that's one reason why companies go public and is the main reason that companies go public in order to raise capital. But there are other reasons that companies go public too. One reason sometime is to cash out insiders or major investors. So venture capitalists, for example, typically like to invest in a company and then hold that company for five years after that they're looking for an exit. Taking that company public allows them to unload their stock on the public markets because it

no longer meets their criteria for what they're looking for. Some other companies actually go public, not because they need the money, but they do so for marketing purposes. So becoming a public company raises a company's profile within the business community and can often lead to new business opportunities and really make them seem like a more legit company than they could before. And then finally, some companies go public so that they can create a public pool of stock for their investors trade in out of. And in many cases today, those investors include the company's own employees, many of whom own a few thousand shares of the stock. And they look,

they're interested in selling it so that they can fund some part of their lifestyle. So there's Many reasons that companies choose to go from being a private company to being public on the exchange, but the number one by far is because they want access to capital. And by contrast, a stock buyback takes place when a company wants to reclaim more of its shares. Can you talk about that? Yeah, so this is a topic that's become really hotly debated with a lot of people, is the topic of stock buyback. So we just talk about a company saying, I need money, and they come public.

They create new shares of stock, sell that on the markets, and that's a way for them to get capital. Well, if a company is big, mature, very profitable, we actually can see the exact opposite thing of that happen, where a company actually chooses to buy back its stock from the public investors. Now, why would a company want to do that? Well, again, let's break it down and let's say that you and me have this business and we have 50,000 shares outstanding. and you decide that you no longer want to own 80% of our company. That's just too much for you. You're willing to give up some of your ownership in the business in order for a higher exchange of profits now.

So I'm, let's say I'm okay with that. Remember, I own 20%. So I have 10,000 shares. You have 40,000 shares. So we decide to take some of the company's profits and to buy out your position in the company. So let's say, to make the math really easy, we give you a lot of money and you do. decide to retire 30,000 of your shares of stock. So we give you a huge chunk of the profits. You

in exchange give the company back 30,000 shares of stock. So now you own 10,000 shares of stock, and I still own 10,000 shares of stock. So after this buyback, I now own 50% of the company, and you own 50% of the company. That's a really simplistic way of saying the exact same thing can happen in the stock market. So with big, big, big companies that are out there, such as Apple, Google, Facebook, etc. Those companies are so big and so profitable that one thing that they do with their enormous profits each year is they buy back their stock from some of the public investors. Now, doing so reduces the total number of shares that are out there that make up the

company and that increases the value per share, at least in theory, of all the shareholders that remain. So that is one thing that companies can do with their capital. in order to make their share price more valuable. Another option that companies have when they are in a solid cash position is to increase dividends. Why would a company do that? Yeah, so let's just talk about what a dividend payment is. A dividend payment is when a company takes some profits that it has or some cash that it has

in its bank account and it hands that directly to its shareholders. And that's something that we actually did before with our business. So our business generated $100,000 in its first year. and that cash was paid directly to us to shareholders. So when cash goes from a business to its shareholders, that's called a dividend payment. And you can understand why that's an attractive thing that some investors like to see from the companies that they own. Not every company that is publicly traded pays a dividend, but the ones that are big, established,

and have huge amounts of predictable cash flow tend to be the ones that pay dividends. So again, Microsoft pays a dividend. Apple pays a dividend, Home Depot, pays a dividend, etc. And what they choose to do is take a portion of the profits that they earn every year and they give it right back to their shareholders. And that's one way that shareholders earn a return on their money. Now, the best companies that are out there not only pay their shareholders a predictable dividend every year, but they also increase the amount of money that they pay

to their shareholders in any given year. And that's by and large, that's something that's companies in the S&P 500 have done for many years. So that's yet another reason why investing in index funds is a great choice because the dividend payment that you get from the S&P 500 tends to be fairly predictable and it also tends to rise a little bit each year. So for a person who's listening to this, this is, of course, an explainer episode for beginners. It's an intro to stocks episode for beginners. How should a person who's listening to this apply this information? What should they do if they want to enter the stock market for the first time and how do they control their emotions, that greed and fear as they foray into

stock investing. Well, Paul, I've been listening to your podcast for many years now, in fact, since the days of when it was you and J. Money doing this. And I know that the advice that you've been giving out to your listeners is spot on with what I would say. You've been an advocate of contributing to your 401k, Roth IRA or regular IRA, whatever tax advantage path is available to you. And just investing consistently into broad-based index funds. That is a time-tested, proven strategy to make group returns in the stock market over long periods of time. However, that only works, or that method of investing only works if you simultaneously pair it with a long-term mindset. If you're going to be investing in the market, you have no control at all over where stock prices head over any given period of time.

And there have been many, many instances historically where stock prices went down that we highlighted before and they stayed down for a period of years. That's why if you know that you're going to need money for something in the next three to five years, that is not capital that you should put in the stock market at all. You're taking on too much market risk. But if you just want to fund a comfortable retirement, if you can invest with a long-term time horizon and you don't need the money for decades, the simplest thing to do is to contribute to your companies 401k if you have one, put money in a IRA or Roth IRA if you have access to that,

or just put it in a regular brokerage account and just dollar cost average into a broad-based index fund over a period of time. And if that's your strategy, believe it or not, the thing that you should be rooting for is you should be rooting for lower prices. Because when prices are going down, if you're contributing, you're buying at better and better valuations. And that means that your future returns have a higher percent chance of being higher than they are average. So that can be such a backwards and counterintuitive thing to do. You're investing in something and then you're rooting for the price to go down. But that's actually best case scenario if you're going to be a buyer of stocks for a long period of time. And I think we're seeing more of that in the zeitgeist now.

People are talking about buy the dip, buy the dip. You know, we're seeing a lot of that online. For sure. And my strategy there is don't even worry about buying the dip, buy on the way up, buying the way down and just focus on the long term. If you can do that, it makes the need to time the market irrelevant. Excellent. Well, thank you so much, Brian. Where can people find you if they would like to know more about you and your work? The best place to connect with me is on Twitter. I'm active there. I'm at Brian Faraldi, and I also have a YouTube channel, which is my name, Brian Faraldi, too. Excellent. Thank you. Thank you so much for having me, Paul. Thank you, Brian. What are three key takeaways that we got from this conversation? Number one,

in the short term, investor sentiment, meaning fear and greed, emotion, drive stock prices. Stocks trade in the short term based on enthusiasm, excitement, optimism, and yes, a little bit of greed. Stocks trade based on the enthusiasm and the excitement of the investor community at large. And we're social creatures and we take our cues from other people and the herd mentality is a real thing. There are long periods of time when investors are extremely excited to be buying stock. They're extremely bullish or optimistic about the future prosperity of American businesses, and they are willing to pay higher and higher prices to own stocks. So in the short term, emotions drive the market. Fear and greed drive the market.

But in the long term, the market is a weighing machine. meaning it looks at the numbers, it looks at profits, it looks at growth potential, it looks at other alternative investment opportunities, and in the long term, it weighs what companies are worth. So in the short term, the market is a voting machine, and in the long term, it's a weighing machine. But the bad thing is that exact process can happen in reverse. If investors as a group suddenly turn bearish or fearful about stock and stock prices, they can sell off those stocks, which causes the price to go down. And when prices are going down, that fills a lot of investors with fear that the prices

are going to continue going down. And again, we take our cues from each other. The best quote I've ever heard on what happens to stock prices in the short and long term comes from Benjamin Graham, who is one of Warren Buffett's mentors. He says, in the short term, the market is a voting. machine. But in the long term, the market is a weighing machine. What that means is that in the short term, stock prices move up and down based on the emotions of market participants, broadly speaking. However, over a long period of time, what moves stock prices is the underlying economic

earnings power of the companies that are in that next, i.e., how profitable are those companies, and what direction do those companies profits head in? So that's the second key takeaway. And that drives home the idea of why the daily fluctuations, the market volatility, what happened today or this week or even this month is noise. What happened over the span of the last five years, that's meaningful. And that leads to the third key takeaway, which is the case for being a long-term buy-and-hold investor. There's a wonderful study that I saw where they looked at if you bought the S&P 500 and held it for various periods of time, what was the odd that you earned a positive real return

on your money? So a real return, meaning after accounting for the effects of inflation. And what the study found is, if you buy the S&P 500 and hold it for one month, your odds of making money are about 60%. 60% of the time, you'll have a positive return. Well, if you stretch that out to one year, so you buy an S&P 500 and hold for a year, the odds of you making money go up to 69%. If you hold for five years, it's an 81% chance. Ten years, it's an 89% chance. And if you buy and hold the S&P 500 for 20 years, you have made money in real terms 100% of the time.

Said differently, there's never been a 20-year period in U.S. stock market history, and that includes world wars, presidential assassinations, pandemics, economic shots, depression, etc., where you lost money if you bought and held it for 20 years. The longer your money stays in the market, the higher of a probability you have of making a real return, meaning returns after inflation. So if you have a long time horizon 20 years or more, i.e., if you're investing for retirement, or if you're investing for a young child's college funds, you don't need to worry about what's happening this week, this month,

heck this year, because you are playing the long game. Those are three key takeaways from this conversation with Brian Feroldi, who laid out an explainer episode, Stocks 101. Please share this with anyone in your life who has said to you, you know, I really need to learn more about investing. I just haven't done it yet. Geez, I've been meaning to learn about the market. I've been meaning to learn about stocks,

but I just haven't gotten around to it. If you know someone like that, please share this episode with them. Might be a coworker, a sibling, a friend, your old college buddies. Share this episode with them so that it demystifies the world of stocks, makes it approachable, makes it so that everyday people,

you and me, can participate in the wealth and innovation and productivity that's being created around us. You can subscribe to the show notes for this podcast for free at afford anything.com slash show notes. Also, do me a quick favor, please. Open up whatever app you're using to listen to this show and hit the follow button so you don't miss any of our amazing upcoming episodes. And while you're there, please leave us a review. I want to give a shout out to Bamathan 003, who recently left us a resource.

review on Apple Podcasts, five-star review, that says, quote, as someone who works for a furniture manufacturer, she hit the nail on the head with the inflation episode. Perfect explanation. Thank you so much. And for those of you who haven't caught that episode yet, we aired that episode on February 18th, 2022. That's episode 365. You can navigate to it at afford anything.com slash episode 365. I also want to give a shout out to Miss Sarchasm, who says,

quote, absolutely love this show. The topics discussed when guests come on are meaningful and deeper than just money. Paula's deliberate, sophisticated, and well-thought-out responses

to questions is absolutely incredible. I also love the sometimes juxtaposition of Joe's opinions, which broaden my mind. She also says, and I'll read this,

one thing, Joe, please stop interrupting Paula. I know you're excited and passionate, but I know you can do better. Ms. Sarchazen, thank you for saying that. Speaking up in Joe's defense, I actively encouraged him to jump in, interrupt, like, don't let me monologue. I actively encouraged him to do so. We've talked about it behind the scenes, and I was like, Joe, please, I don't want to stand on my soapbox and monologue. If you're feeling something, if you're moved, please jump in.

because then we can create that type of dynamic conversation that often happens between friends at bars, right? You know when you're out, you're having a drink with a friend, and you're swapping stories, and you're just like, blah, blah, blah, and then this happened, and then your friend jumps in and is like, blah, blah, blah, and then this happened. And then the energy level just rises and rises and rises because you're with your friend and you're excited and you guys are having a great time. That's the level of energy that I'm trying to bring to the Ask Paula and Joe episodes,

and that's why I'm encouraging more of that. So a little peek behind the scenes as to what's going on. But thank you for saying that. And thank you for your beautiful and really heartfelt review. I love it. I really appreciate it. I also want to give a shout out to Dan Stratt fan, who left a review that said,

quote, one of the few podcasts that I listen to every episode. Paula does a great job disseminating information on both topics that are new to me and topics that I could use a deeper dive into. Each episode, it's obvious that her and her team have done their homework to present complex ideas in an easy-to-absorb way. Thank you, Paula, Afford Anything Team, and Joe for your continued hard work that we can all benefit from. And thank you, Dan, for leaving that review. Thank you for taking the time to leave such an awesome and detailed and amazing review.

That warms my heart. I really appreciate it. And thanks to everyone in this community, whether this is your first episode or you've been with us for years. Thank you for being part of the Afford- Anything community. Remember, you can subscribe to the show notes for free at Afford-anithing.com slash show notes. And you can chat with other members of the community at afford-anything.com slash community. You can also find me on Instagram at Paula P-A-U-L-A-P-A-N-T. Thank you so much for tuning in. My name is Paula Pantt. This is the Afford- Anything podcast.

And I will catch you in the next episode.