We Study Billionaires - The Investor’s Podcast Network - TIP437: Why Does The Stock Market Go Up? w/ Brian Feroldi

Starting point is 00:00:00 You're listening to TIP. Hey, so a quick note before we start today's episode, Clay, Robert, and I will be attending the Berkshire Hathaway annual shareholder meeting on April 30th. If you don't know, Clay and Robert, be sure to check out their show Millennial Investing on our network. This event is in Omaha, and for those who aren't familiar, all you need to attend the meeting is to be an owner of one Berkshire B-share, which today is around $330. Also, each shareholder is entitled to a maximum of four meeting credentials, so even if you're not currently a shareholder, you might be able to attend through someone you know. We'll be sending details on this to our email subscribers soon

Starting point is 00:00:36 in case you're interested in meeting up with us. My guest today is Brian Ferraldi. Brian is a financial educator and writer for The Motley Fool. Be sure to check out episode 375 where Brian and I discussed how he creates an investing checklist. Brian has written a new book titled, Why Does the Stock Market Go Up? It's a simple breakdown of questions you have likely had a lot. long your investing journey. For example, we discuss how compounding works. What is the S&P 500, the Dow Jones, the NASDAQ, and how they came to be? Why the stock market typically goes up over time? Why we call it a bull market or a bear market? Valuation metrics like the PE ratio as well as things like earnings yield and dividend yield. How the 401k originated from an accident and a whole lot more.

Starting point is 00:01:21 I always have a great time talking with Brian. He's the perfect guy to write such a thoughtful book. It's the book I wish I had 10 years ago when I started learning about investing. So for some, this will be enlightening for others. Maybe it's a refresher. But I would bet that you will learn something you didn't know before. So with that, enjoy this discussion with Brian Ferraldi. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most.

Starting point is 00:01:51 We keep you informed and prepared for the unexpected. Welcome to the Investors podcast. I'm your host, Trey Lockerbie. And today we have back on the show, my friend Brian Feraldi. I'm so excited to have you back. Welcome. Trey, awesome to be back. Thanks so much for having me.

Starting point is 00:02:15 I got to say, I love this book. I finished it in a few hours. It's a very easy read, very simple. And that's kind of the point, right? It's getting back to basics. And I looked at it as sort of a way to fill in these knowledge gaps that you might have, even if you're a experienced investor, right? There's things in that book that I feel like just kind of glue things together.

Starting point is 00:02:35 So for me, for example, it's like, I don't know if you've ever tried to learn how to play guitar. It's like, you know, if you start to learn how to play a G chord, but it's sort of like a finger shape. You could play guitar pretty easily just by learning the shapes of the chords and hey, you put your finger here and the here. But then you don't necessarily know what the notes are that you're playing, you know, why you're playing those notes, why they sound good together, et cetera. So I feel like this book kind of got into the theory almost of why things work the way they do. And I highly recommend it. So congrats on the book. I just got to say that much.

Starting point is 00:03:07 Thanks so much. That means a lot. And yeah, like you, I've been studying the markets. I've been investing for almost 20 years now. And I intended the book to be everything that's extremely simple, right, are the most basic things about the market. But I even learned stuff as I was researching and writing it. One thing that I want to kick off here with is the power of compounding, because it's something we hear about a lot. You know, I'm reminded constantly of how our brains are just not equipped to process compounding. It's just a constant reminder. As much as we understand or think we understand, it's just elusive to a lot of people, especially. And so, for example, I like to reference the fact that, you know, 99% of Warren Buffett's current net worth was achieved

Starting point is 00:03:46 after his 65th birthday, you know, like after retirement age. I think that would shock a lot of people. And it's just an illustration of compounding. So what might be some other scenarios that our listeners can relate to that would showcase the power of compounding for them? The whole reason I want people to become familiar with what the stock market is and how it works is that so they can harness the market's awesome power to turn small amounts of money into large amounts of money over long periods of time. So one real quick example that showcases that to me just so beautifully is let's create a fictional person. We'll call this person Sally. Sally's career started in 1981. Now, why 1981? That just so happened to be the very first year that the 401k

Starting point is 00:04:33 was available to America. Because that was the year that the 401k was invented. Let's say Sally earned a perfectly average salary during that time. And let's say that she was okay with money. So she made money. She avoided debt, but she spent basically every dollar that went into her bank account. However, Sally made one really good financial decision in her life. And that is on the first day of her career, she signed up for this brand new thing, the 401k. And Sally didn't understand what it meant, but she decided to put $400 per month or $100 per week into this 401k.

Starting point is 00:05:09 Now, every time she got a letter in the mail saying, here's what it's worth, she didn't understand what it meant. And she took it and threw it away. She never, ever looked at it. Well, fast forward the clock 40 years. Sally kept this going up. She never increased her contribution amount at all. And in 2020, end of 2020, she decides it's time to retire. So the question is, how much money is in Sally's 401k? And I guess I should say she invested it in the U.S. stock market. So she earned the average return during that 40-year career. Well, if you're good at math, you'll see that Sally invested a total of $192,000. That was her contribution. But how much was her worth at that point? $3.03 million. It was literally 15 times the total amount that she invested. How did she do that?

Starting point is 00:06:00 The answer is she harnessed the power of the greatest wealth creation machine of all time, the U.S. stock market. And that just shows how important it is to put compound interest on your side. Now, during that time, it was a normal couple of decades for the markets. The markets went up about 10 to 11% annualized over that period. There were definitely numerous bear markets during that time that just showcases to me how a little bit of money invested consistently into the market can become a huge amount of money. And nothing illustrates the point of that compound interest more than this fact.

Starting point is 00:06:32 So when she retired at 2020, she had $3 million to her name. If the market kept going up 10% on average, every year that she invested after that point would create $300,000 in extra wealth. That's just 10% times the $3 million that she had. That one extra year would create more wealth than all of the contributions that she had over a 40-year period. That's why getting compound interest on your side is so powerful. Yeah, I love in the book how you also zoomed out. So you mentioned the U.S. stock market and investing in that. And this percentage of it going up, so like over the course of the year, maybe it's a little over 60%, but over 20 years, it's 100% that it goes up on occasion.

Starting point is 00:07:17 So that brought up a lot of points that you make in the book around indexes and what they are. So for example, I actually remember very clearly the day I was in my car listening to the radio and they said something to the effect of the Dow was down two points today. And I'm sitting there going, what does that mean? I have no idea what that means. I don't know what the Dow is. I don't know what the points mean. Is that good?

Starting point is 00:07:41 Is it bad? Is it terrible? Should I be freaking out? And I just remember acknowledging how ignorant I was on just the concept of this huge machine that almost runs the world, right? And that felt so silly to me, even though at the time I was a musician and I was thinking, I'm never going to need to know this stuff. But it just scared me to some effect to just want to learn about it. So for our audience, let's just start with the Dow. What is it? And how did it come to be? Well, Trey, I've had the exact same experience that you have. have been several times in my life when the words Dow Jones Industrial Average and points and up and down entered my sphere of knowledge. And I was just like, one, I don't know what the Dow Jones

Starting point is 00:08:22 industrial average is. Two, I don't know what a point is. Three, I don't know why they're adding points to subtract the points today. But I guess more points is good, less points is bad. But once somebody explains what the heck the Dow is in the history of it, it all became crystal clear, at least to So rewind the clock to the late 1800s. In the late 1800s, there were publicly traded stocks, just like there are publicly traded stocks today. And the way that you got information about the stock market back then was in the newspaper. Now, the head of what would become the Wall Street Journal, his name was Charles Dow. And his paper was printing stock prices every single day in the paper. And it was just tables with rows of company names and stock numbers and how much

Starting point is 00:09:07 they move up or down that day. And this table just had a whole bunch of information in it, but there wasn't a way that Charles Dow could summarize what happened in the stock market that day for his readers. So he asked his business partner, his name was Edward Jones for help. So what the two of them, a surmise is that they would look at the 12 largest and most popular companies at the time. Those were largely industrial companies, so big manufacturers. And they took the 12 stock prices that they printed for those companies and they added them up. Then they divided that total that they got by 12. Now, what's it called when you add a bunch of numbers up and then divide by the total of numbers? That's called averaging the numbers. So they invented the Dow Jones Industrial

Starting point is 00:09:52 average. And suddenly, by reporting this number to their readers, they could give their readers a sense for what happened in the stock market that day. And that was launched in 1896 and it is still referenced today. Now, the Dow has changed over the years to kind of keep up with the changing times. Those 12 original companies that were putting there were eventually replaced. And the index in 1928 was upgraded from just 12 stocks to include 30 stocks. If you look at the Dow Jones today, it includes big companies such as Apple, Disney, and Home Depot. But that's what a stock indices is. It's when a small group of stocks are used as a proxy for what happened in the entire stock market today. And the three Most popular stock market indices today are the Dow Jones Industrial Average, the S&P 500,

Starting point is 00:10:40 and the NASDAQ composite. So you mentioned the 12 are now 30 companies. How often are the companies being swapped out? There's a committee that determines what companies go in and which companies go out. And the swapping out happens every couple of years or so. I don't know if it's on a preset schedule or I know that they meet annually or bi-annually and come up with this. So it's not something that happens very frequently, but it happens.

Starting point is 00:11:05 whenever the committee determines that some company no longer is representative of what the American economy is. So they kick that out and they bring in something fresh. You just mentioned the S&P 500, the NASDAQ, and obviously the Dow. Walk us through the differences between the three. So let's start with what is the S&P 500. Well, back in 1923, there was a company called Standard Statistics. And Standard Statistics saw how popular the Dow Jones. Jones Industrial Average had become, and like any good capitalist company, they said, hey, let's make our own index to compete with the Dow. So they started out by tracking 233 companies. Now, later, standard statistics merged with a company called Poor's Publishing, creating the Standard and

Starting point is 00:11:55 Poor's company. Now, in 1957, in an effort to really ramp up their ability to compete with the Dow Jones, they made some changes to the standards index. First off, they expanded it from 233 companies to 500 companies. That was a stark difference between the Dow, which only tracks 30 companies, and the S&P 500, which tracks 500 companies. The logic is by tracking hundreds of companies versus just 30, you get a more accurate information for what's happening in the market. The second change that they made and was a big difference between them and the Dow was

Starting point is 00:12:27 the Dow used the price of a company's stock to determine how much it was weighed in the index. So the higher the dollar amount of one share, the larger the role is in the Dow Jones Industrial average. Now, the reason that they did that is because they were calculating everything by hand in the early days. And they knew the stock prices of the numbers. So it was a very simple way for them to track and create this index. However, the share price of one share of a company isn't a good metric for figuring out how big and how important is this company. A better metric for doing that is what's called market capitalization. Now, market capitalization is the dollar price of one share times the total number of shares that are

Starting point is 00:13:08 outstanding. So that is the total equity value of that company's stock. And the S&P 500 weighed the index according to market capitalization, not the price of one share. So those two changes, the 500 and the market cap weighing really helped the S&P 500 to catch on. And now it's a more popular index in many ways than the Dow Jones Industrial average. It actually surprised me about the price weighting of the Dow because that just seems so silly to me, especially this day and age. I mean, I get what you're saying about handwriting out the calculations and doing, it's basically a shorthand of the market. But you're right, to wait something based on the price of the share is so silly.

Starting point is 00:13:49 How is that still even in existence? Yeah, there's been lots of calls for the Dow to update its data and to do things differently. But one of the big advantages that the Dow has over the S&P 500 is it's been in existence longer than really any, any other index. So at this point, it now has data going back almost 130 years versus the S&P 500, which in its current form, was created in 1957. So that long market history makes the committee, I think, very resistant to changing things. But for that reason, that's one reason why many professional investors measure themselves against the S&P 500, not the Dow. All right. Let's talk about the NASDAQ because you brought that up. That's kind of the third in this trifecta here. Walk us to what the NASDAQ actually is and how it came to be.

Starting point is 00:14:34 So one of the most popular stock exchanges ever and still to this day is the New York Stock Exchange. And that was just a place in Wall Street in Manhattan where investors and businesses got together to buy and sell or exchange shares of stocks. I mean, one simple way to think about that is a stock exchange is kind of like a farmer's market. You go to a farmer's market with money, you give that to the food producer, they give you the food. Stock exchange is the exact same thing, except for instead of exchanging food for money, you're exchanging shares or ownership and businesses for money. So the New York Stock Exchange is one of the oldest, and today is the largest stock exchange in the world. But the New York Stock Exchange was what started out as a physical place where people met up in person to exchange hand to hand.

Starting point is 00:15:18 Well, that worked well for many years, but in the 1950s and 60s, computer technology was advancing very, very, very rapidly. And one problem that existed at the time was it was hard to get accurate stock prices to all market participants at the same time, right? There was a lag with stock prices depending on where you are in the world. Well, computers could be used to kind of solve that problem and make all trading happen at the same time so that prices could be updated everywhere. So this group called the National Association of Securities Dealers, the N-A-S-D, decided to create their brand new stock exchange in 1971 that was 100% electronically.

Starting point is 00:15:58 So this was computers talking to each other. So technology had advanced enough at that point. So they launched the stock exchange and called it the National Association of Security Dealers automated quotations or NASDAQ. Now, this new stock market was very appealing to a lot of technology companies. One, because it was more futuristic. And two, because the NASDAQ was buying technology. products from the tech companies. So that's why companies like Intel and Microsoft and Apple

Starting point is 00:16:28 chose to list their stocks on the electronic stock exchange, the NASDAQ, instead of the in-person stock exchange, the NYSC. Now, as the NASDAQ has grown in popularity, in fact, today it's the second largest stock exchange in the world, still behind the New York Stock Exchange, but it's the second biggest in the world. There are now thousands of companies that are listed on the NASDAQ stock exchange. And when the NASDAQ stock exchange was created, just like the Dow and the S&P 500, the people that created it, wanted an easy way to track what was happening with the prices, broadly speaking of all the stocks that traded on their index. So that tool that's used to track the prices of all those companies that trade on the NASDAQ is called the NASDAQ composite. And that is

Starting point is 00:17:09 what's reported in the paper. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building technology under censorship and authoritarian pressures. These aren't abstract ideas. These are tools real people are using right now. You'll be in the room with about 2,000 extraordinary individuals, dissidents, founders, philanthropists, policymakers, the kind of people you don't just listen to but end up having dinner with. Over three days, you'll experience powerful mainstage talks, hands-on workshops on freedom tech, and financial sovereignty, immersive art installations, and conversations that continue long after the sessions end. And it's all happening in Oslo in June. If this sounds like your kind of room, well, you're in luck because you can attend in person. Standard and patron passes are available at Osloof Freedom Forum.com with patron passes offering deep access, private events, and small group time with

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Starting point is 00:21:03 Sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. So how many companies are in the NASDAQ composite today? My estimation, the last time I looked, the number was just over 3,000, somewhere around 3,200 companies. Got it.

Starting point is 00:21:33 All right. So going back to that experience of sitting in the car, listening to the radio, hearing about the Dow up two or three points, It brings up this question of why are we measuring by points rather than percentages? I know sometimes you use both, but why is the preference always around points for some reason? As we're speaking right now, I'm looking at the live view of the Dow Jones Industrial average and the total value of the Dow is currently 34,564. So that's how many points comprise the Dow Jones Industrial Average current price tag. And the Dow, as we speak, is currently up 86 points on the day.

Starting point is 00:22:12 And it's really good for newspapers, for headline writers to say things like the Dow was up 300 points today or the Dow fell 500 points today or whatever the number happens to be. That's a big number that is like often entices clicks and viewership. However, the total points that the index goes up and down really doesn't matter all that much. What's far more relevant is the percentage gain in the index on any given day. So again, right now today, the index is up 88 points as I'm reading this. But on a percentage basis, the index is only up 0.25% today. So if you were a headline writer, what would sound more interesting? The Dow was up 80 points today or the Dow was up 0.25% today.

Starting point is 00:22:55 So we still largely, at least newspapers, still largely referenced the indexes in terms of points. But points are like facts and it's really percentages that provide the context that investors need. So when we talk about points, we're not talking about basis points of percentages, right? Because I think a lot of people could confuse that. We're actually talking about a composite of points that make up the index and how much that has increased or decreased. Is that correct? That is correct.

Starting point is 00:23:21 So the NASDAQ is currently up literally 86 points on the day, meaning yesterday it was 34,4190. Currently, it's 34,570. So it's up 80 plus points on the day. And when the stock market does go up like that or goes down, we either call it a bull market or a bear market. And this was a fun history lesson in the book that I was also pleased and surprised by because these are just terms you accept and acknowledge, like for no reason off the top, it's just what everyone says. And you go, yeah, yeah, I know. It's a bull market. Why do we call it a bull market and why do we call it a bear market?

Starting point is 00:23:58 Like everything, it's a nickname that was given to different types of markets. but broadly speaking, a bull market is when prices are rising and are expected to continue rising. Now, why is it called a bull market? Well, if you can picture the head of a bull with horns, a bull attacks by thrusting its horns upward. So that's the direction that the bull attacks in, hence why it's called a bull market. Conversely, a bear market is when prices, market prices have fallen by 20% or more from a recent high. and that's because the way that a bear attacks is by swiping its paw downwards at its prey. So who came up with those terms?

Starting point is 00:24:37 I don't know. But like you said, they've become common ways for us to describe whether market prices are rising, a bull market or falling, a bear market. I love it. All right. So now I want to get into why companies go public in the first place. And one major point, I think, if you surveyed 100 people, I think most people would actually get this first point wrong, which is if I buy a stock today, does the company get that money? So, for example, I would estimate that a lot of people who, in just the last year,

Starting point is 00:25:09 opened up a Robin Hood and bought some Tesla, for example, think that that $100 is going towards a new battery, right, or a new whatever. Now, walk us through why that is not the case. There are numerous reasons why companies go public, but typically the number one reason that companies go public or choose to list on a public exchange is because they need to raise capital. So there are several ways that companies go from being private to being public, but one of the most common ways that companies do so is through an initial public offering or an IPO. This is when a company that is privately held creates brand new shares of stock and takes that stock and

Starting point is 00:25:47 sells it to the public by listing its stock on a public stock market exchange, such as the New York Stock Exchange or the NASDAQ. Once that happens on the very first day of trading, investors pay, buy those shares from the company. The company gives those shares to the investors. And if you buy at the IPO, you are literally giving your money to the company. However, once the company gives those shares and sells them for the very first time to investors, those shares no longer belong to the company. And all the prices that we see going up and down every day on the various stock markets are one investor selling their shares in their stock to another investor. So if you go on the stock market and want to become an investor in Tesla. And like you said, put, say, $100 into

Starting point is 00:26:34 Tesla today, you go and place an buy order that your broker takes your money and finds another investor that's willing to sell their Tesla stock to you. And that's when the exchange happened. So Tesla, the company, is in no way involved in that transaction. They do not get the money when you buy a stock. Only the other investor on the other side of the transaction does. All right. So let's dig into why the stock market goes up, which is the title of the book. And let's get into all the nitty gritty around earnings and how they grow and how the price is affected by that, et cetera. So walk us through why the stock market goes up and why it tends to go up consistently over time. So let's back up and just answer the question. What is a stock? So a stock literally represents fractional ownership of a corporation. Stocks were invented because they vastly simplified the record keeping for who owns how much of a given company. So when we look at the S&P 500, for example, that means that there

Starting point is 00:27:37 are 500 publicly traded companies on the U.S. stock market. And by adding up the share price of all those companies, when you go to buy them, you literally become a infinitesly small owner of all 500 of those companies. So why does the stock market? in the S&P 500, why is it risen over time and why should it continue to rise, hopefully, for the rest of our lives and many years beyond that? Well, when you become an owner, a shareholder of a company, you now have a legal claim on that company's assets, what it owns, and that company's current and future profits. So, as a company generates profits, those profits don't belong to the company, they belong to the owners of that company, which are the shareholders.

Starting point is 00:28:26 By and large, if you look at over a long period of time, the earnings or the profits of all of the companies in the S&P 500 tend to rise over long periods of time. Now, there are many underlying factors that cause those profits to rise, including population growth, inflation, innovation, stock buybacks, productivity, things like that. But broadly speaking, over long periods of time, the companies in the S&P 500 tend to become more and more profitable each year. You, as a shareholder of those 500 companies, have a legal claim on a never-ending stream of growing profitability. For that reason, the value of the S&P 500 tends to go up when measured over long periods of time, although, as I know that you know, over short periods of time,

Starting point is 00:29:16 the stock market can visit some very interesting places. Well, in this point, specifically ties back to the power of compounding, right? And there's this great Benjamin Franklin quote in your book that I had, I don't think I'd read before, but I love it. It says, money makes money makes, and the money that money makes makes money, right? So give an example of, say, the better coffee company, which you have in the book, or Starbucks opening up shop next door, how opening up more and more doors, then the intention of raising that money goes towards the expansion and then, therefore, the compounding of earnings. Yeah, so a real simple example. I think everyone can rate to is Starbucks. So everyone here that's listening is familiar with

Starting point is 00:29:56 Starbucks. And as I look at Starbucks valuation today, Starbucks is currently worth $100 billion. That is the total equity value of Starbucks common stocks. Starbucks is a gargantuanely huge company. However, when Starbucks came public nearly three decades ago, it was a far, far smaller company than it was today. So at the time, the company only operated a few hundred stores largely around the west coast of the United States. Now, one reason that Starbucks went public because it wanted capital, it needed capital, so that it could open more stores. Why did it want to open more stores so that its revenue and its profits would continue to grow and the value of Starbucks would continue to grow? So this is one very easy way that investors can visualize how companies can take capital, reinvest it in themselves, and grow over time.

Starting point is 00:30:53 I don't know the numbers exactly, but let's just say at Starbucks and the initial public offering, it had 200 total stores outstanding. So there was 200 Starbucks in the world. Well, fast forward today, and there's about 17,000 Starbucks in the world. So the total number of Starbucks that exist around the globe has gone up almost a hundredfold over. its lifetime. Well, with literally 100x more stores available today than the were 30 years ago, what do you think has happened to Starbucks revenue? What do you think has happened to Starbucks profits at that time? It's up tremendously. And the reason that Starbucks was able to do that is because it raised capital from investors. It took that capital. It built new stores.

Starting point is 00:31:35 Those stores generated profits. Those profits were reinvested to open up even more stores the next year. And that process has happened over and over and over again. So that's how Starbucks started as just a very small coffee chain in the northwest of the United States, and now is a global phenomenon with tens of thousands of stores. During that time, as it was expanding, and its revenue was growing and its profits were going, the total value of Starbucks has grown in lockstep with that. Now, not in perfect lockstep. There were times when Starbucks stock price and equity value was growing very quickly, faster than its store count. There were other times when Starbucks stock price was falling, even though the total number of Starbucks was going up.

Starting point is 00:32:17 But over long periods of time, the reason that Starbucks is worth $100 billion today is because the company's revenue and profits are many, many, many times bigger today than they were when Starbucks first got started. And another reason that the stock market goes up that you touched on a little bit earlier is innovation. And this one is, again, sort of easy to understand in theory, but you laid out this great example that I just want to highlight, which is basically the fact that in 1990,

Starting point is 00:32:44 not a single person owned a smartphone. And as of 2020, you had 3 billion people have a smartphone with over $700 billion of revenue coming from this brand new innovation. So what are some other innovations that you're seeing today that could emulate something like the smartphone that will advance the stock market forward in the future? I truly believe that right now we are going through the most innovative and most disruptive periods in human history. And it's hard for me to wrap my head around what the world could possibly look like just 10 years from now with the number of innovations that are out there.

Starting point is 00:33:22 Now, there are literally dozens of innovations, innovative technologies that are currently emerging and promise to change things. And like any innovation, not all of them will matter. Some of them will flame out and some of them won't matter at all. However, it's possible that even just one or two with these could become as important to humanity and impactful as like the internet is. And think about all of the businesses that exist today because the internet came to be 40 years ago. So here's a couple that I'm currently looking at and I think are very exciting. 3D printing, artificial intelligence, autonomous vehicles, blockchain technology, cloud computing, carbon sequestration, CRISPR, cryptocurrencies, cybersecurity, DNA computing.

Starting point is 00:34:07 desalinization technology, edge computing, electric bikes, electronic payments, electronic vehicles, geothermal heating and cooling, holograms, the hyperloop, the internet of things, nanotechnology, online dating, personalized learning, personalized medicine, personalized insuring, plant-based meat, plastics 2.0, precision biology, robotic surgery, et cetera, et cetera, et cetera. I mean, there are literally dozens of innovative categories that are happening right now. And while many of these categories were likely to flame out and become nothing, just a few of them could really be so impactful on humanity that it profoundly changes our economic system. So not to single out ARC, but I'm going to single out ARC here because ARC's thesis is investing in innovative technologies pretty specifically, right? And they've got a lot of heat over the last year because they shot up in value.

Starting point is 00:34:59 I mean, they're an ETF, shot up in value. And has since gone down something over, I think, 50%. So that begs the question. does the stock market sometimes go down? We covered why it went up. What is the inverse of that? So you have to think of the stock market as a live continuous auction that's happening at any period of time. And when you look at just like how any given company is valued at any given point, there's really two factors that matter that would determine the valuation or the price of that company at any given time. One is the underlying profitability of that company and how those profits are

Starting point is 00:35:35 expected to change into the future. So companies are typically valued. One simple way to value companies is on a multiple of their profits. A very simple metric for tracking that is called the price to earnings ratio or sometimes called the PE ratio. So all of the things held equal. Let's say a company is doing $1 in profits in earnings per share and investors value that company at 20 times profits. That stock is trading at $20, 20 times a dollar in earnings per share. So you can see with that, $20 valuation, only $1 of that current valuation is the current in earnings power of that company, and the remaining $19 is the amount that investors are willing to pay for the future profits of those companies.

Starting point is 00:36:18 Well, humans are emotional creatures, and when we see something bad happening in the world, or we become fearful or less certain about that company's profits showing up when reaction that people have is to sell their stock in anticipation of a decline in earnings. Now, historically, when you look at the big bear markets that are happening, the big times when stocks have gone down, they're typically associated with some kind of major bad macro event. So that could be the Great Depression of 1929. It could be World War II. It could be a political event like Watergate or assassination. It could be the back downside of excess speculation, such as when the dot-com crash happened. It could be a financial crisis, which has happened several times in the U.S. or it could be a global pandemic like we saw in 2020. But there's usually a some kind of bad macro thing going on that causes prices, investors to become fearful. And as investors become fearful, they race for the exits and they rush to sell their stock. That initially causes stock prices to fall, which in turn creates even more fear amongst more other investors and stock prices fall again. And that process cycles on itself again and again and again.

Starting point is 00:37:27 And that's why stock prices can sometimes dramatically decline. And when that happens, it's called a bare market. I love that you highlight the PE ratio there because it's something that is so commonplace when it comes to valuation. Obviously, there's lots of ways to value a company, but this is like the most shorthand, quick snapshot of evaluation of a company that most people adopt. And last time you were on our show, you brought up this really great point that you should maybe not focus on the PE, especially if there's a high growth company at hand, meaning when a company is in high growth mode, earnings is not necessarily the priority. So you have to kind of project out what those earnings are going to be in the future and then

Starting point is 00:38:10 determine what the price multiple will be on that. So just to highlighting that fact for most people who are getting into investing, and I recently interviewed Michael Mobison on the show, and he likes to tell his students at Columbia that you have to earn your multiple, right? You have to tell him why you're even using a multiple in the first place. So I'm just highlighting for people that While this is so commonplace in shorthand, it is nuanced and there is a lot more context involved. But one piece of the PE ratio that we haven't covered that I want people to kind of understand is that if you inverse it, you are actually getting a yield that you're expecting from that. So walk us through how that works.

Starting point is 00:38:46 So let's go back to our very quick example that we had before. A company is doing $1 in earnings per share. That company had a 20 PE ratio on it at the time. that gives us a stock price of $20 per share. However, if we take that P.E. ratio of 20 and we invert it, we can also get the earnings yield that we get as an investor from buying that company. So let's say I go out and I want to buy that stock. I pay $20. I get the stock. And I now have a claim on $1 in earnings per share. What is my earnings yield on that? Well, the answer is the inverse of 20 or a 5% yield on my share.

Starting point is 00:39:27 investment. That can be a helpful numbers that investors can use in their head because it allows you to compare the earnings yield on, say, a company or an index and compare it to something like bonds or CDs and the interest rates on other various things. So like anything, as you just said, the PE ratio and the PE yield are tools that investors can use to value companies. However, there's shortcomings to every tool and there are multiple ways to do it and everything involved of investing. Absolutely everything has tons of nuance to it. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:43:09 risks, charges, and expenses. This and other information can be found in the income Funds Perspectus at Fundrise.com slash income. This is a paid advertisement. All right. Back to the show. As you bring up the earnings yield, it's reminding me of the dividend yield as well. And I remember, again, going back when I first started learning about investing, hearing about dividend yield for the first time, and it just sort of not computing in my brain, even though it is actually a very simple equation and easy to understand. So just while we're on it, let's talk about why dividends are important. and what a dividend yield is really telling us.

Starting point is 00:43:46 Sure. So what is a dividend? A dividend is when a company takes a portion of its profits and gives those profits directly to their shareholders. So that's what a dividend is. So let's go back to our really simple example there. Our company did $1 in earnings per share for the yield. And let's say that that company had no use for that capital.

Starting point is 00:44:09 And it decided to take that $1 in earnings per share and give it directly. to its shareholders. So in this case, the company had a 100% payout ratio. In other words, this company is giving 100% of its profits back to its investors in the form of a dividend. Well, what would be the dividend yield on this company? Well, again, it would just be that $1 in earnings per share divided by the $20 share price. That would be a 5% yield on our purchase at $20. Now, I can tell you that like you seem to be, when I first learned of the $20, you know, dividends and dividend yields. I was like, well, this is like magic, right? It's like free money. Shouldn't I go out and try and find the highest dividend yielding companies that I could find?

Starting point is 00:44:54 And when I came to that amazing discovery, I quickly used some screening tools and found companies that were paying 10% yields, 15% yields, 20% yields. And I was like, great, I just got to buy this company, hold it, and I earn a 20% return on my investment. That sounds great to me. Well, as you can probably guess, if it seems too good to be true, it probably is. The reason that many companies that are out there have very, very large dividend yields is because dividend payments are not guaranteed. If a company isn't earning that profit, it might not be able to make those dividend payments. And typically, if you see a yield, a dividend yield that's very high, that's because a company that was formerly playing a dividend, their stock price has fallen dramatically. Why would

Starting point is 00:45:39 their stock price fall dramatically because the underlying profitability of the business is in question. So when I first started out and I was buying these companies that had yields of 20%, I quickly learned that they had to stop paying their dividends because the business was falling apart. And that caused me to not only lose out on those dividend payments, but the stock that I bought continued to fall dramatically. So I learned the hard way that if a dividend yield seems too good to be true, it probably is. I would add another indicator to that, which is to see if the company is going into more and more debt just to keep up with that dividend that they promised investors. Because you do actually see that as well.

Starting point is 00:46:19 All right. Let's talk a little bit about timing the market. Now, there's that old saying it's not timing the market. It's time in the market. And how timing the market is kind of a fool's errand. So right now, you're seeing in the markets a lot of volatility, a lot of people are projecting the economy will be either good or bad, inflation rising or falling, etc. Should we, as investors, stop investing if the economy is bad?

Starting point is 00:46:47 So it's very tempting to look at what's happening in the world. And if you see negative headlines, a very natural feeling is to say, I can't invest right now. It's too risky to do so. I mean, look what's happening today. We have inflation. We have a war that's going on. The pandemic is still out there.

Starting point is 00:47:07 is a scary time economically to be investing. But one investor that I really like a lot named Ben Carlson, he created this great chart in one of his books he wrote that just blew me away when he read it. So he did a quick study and he found out what are the annualized returns of the S&P 500 at various periods of unemployment in the U.S. So unemployment, the higher the number, the more people there are looking for jobs. Well, what his analysis found was that when the unemployment rate in the U.S. is under 5%. The annualized return of the S&P 500 is 3.9%. 3.9%. So when economic times are really, really good, unemployment rate is very, very low, the S&P 500 returns about 3.9% per year. Conversely, when the unemployment rate is over 9%, horrific, right? So many people are out of looking

Starting point is 00:47:58 for jobs, the annualized return of S&P 500 is 24.5%. So literally six times higher return from if you invest during periods of high unemployment than low unemployment. Now, how could that be? Why on earth would investing when the economy is in terrible shape do better than when the economy is in great shape? Well, typically, when the unemployment rate is low, the economy is doing very, very well. And when the economy is doing well, investors are in a good mood and investors tend to pay higher and higher prices for stocks when they're in a good mood. That lowers that earnings yield that we talked about before. And that means that future returns are going to be lower. So it makes complete sense to me why the returns of the S&P 500 are low when economic

Starting point is 00:48:46 times are good. Take that and flip it around on its head when times are bad. When the unemployment rate is very high plus 9%. That's typically because there's something really, really bad that's already happened in the economy. When there's something really, really bad going on, stock prices typically are down hugely from their high. So the earnings yield is higher and investor sentiment is very, very low. So while it can be very tempting to look at what's happening in the newspaper and said, I can't invest now. It's too risky. More often than not, when you feel that way, that's actually the best time to put capital to work. Yeah, I was going to say, Is that because, you know, if unemployment is high and the companies don't have that payroll expense, so therefore their earnings are higher?

Starting point is 00:49:27 I mean, that was kind of what I was going to, but it didn't sound like that's quite correlated. Something that is seemingly less risky is something that I think people understand a lot less even than stocks. And that would be bonds. We've talked a lot about stocks. I'd like to quickly touch on what a bond is and especially how they are priced, because this can be a little bit elusive to most. So everybody is familiar with a bond, especially if you've ever bought a house. So let's say you want to buy a house that costs $500,000, but you only have $100,000. What do you do? Everyone knows the answer to that question. You go to a bank and you get a mortgage. So you borrow the $400,000. You make the purchase. And in exchange, you agree to pay back that loan over some period of time. In the U.S., the most common time period to do so is 30 years. Well, companies and governments can do that exact same thing. When they need capital and they want to raise it and get like a mortgage, we call that a bond.

Starting point is 00:50:26 So a bond is simply an IOU that an investor loans a company or government money. And the investor is promised to get their money back at some future date. Now, we don't loan money to people and not expect anything in return. So the charge or the cost of that bond is called the interest rate. And that is just the percentage that the borrower has to pay above and beyond the value of the bond in order to access that money. So that's all a bond is. A bond is a debt instrument that an investor makes to a company or to a government. You know, last time you were on our show, I believe we talked a little bit about when to sell a stock.

Starting point is 00:51:04 And I think you even have a checklist for this as well because you love your checklist. And I think it's a great tool as well. But I often see with my friends who are investing in the stock market for the first time, They see this win, this little pop and value, and they go, oh my gosh, my stock just shot up 10%. Should I sell it? That's the question I get more often than not. So talk to us a little bit about what happens when your stock actually performs well, how and when you should consider actually selling it. One of the natural things that happens to me when I first started investing is, let's say I bought a couple of stocks and one of them went up a lot.

Starting point is 00:51:37 Another one went down a lot. my natural inclination would be to sell the one that was going up and buy more of the one that's going down. Well, Peter Lynch has a great quote on that, and he basically calls that the equivalent of watering your weeds and cutting your flowers. So so many things about investing are counterintuitive. They are literally the exact opposite of what your natural instinct is to do. So if a company's stock is going up, there's lots of reasons that that could happen. But by and large, the most common reason that that happens is because the company that is behind that stock is succeeding. They're doing something right.

Starting point is 00:52:16 They're executing their game plan. Perhaps they launched a new product or the product is gaining popularity. And the market is rewarding that company for doing well. Conversely, you can say that a stock is falling, especially when compared to the market in general, for exactly the opposite reason. Maybe they're failing to live up to expectations. Maybe their new product isn't getting traction in the market. Maybe the company is having trouble with execution. So when I first started investing, my natural inclination was to buy more of my losers

Starting point is 00:52:45 and sell my winners early. In fact, I now do the exact opposite. If a stock I own, if the business isn't doing well and that stock is falling, I don't buy more of that stock. And if a stock is going up, that actually excites me as an investor. And that would be the one all things held equal. I would rather put capital in. What you're touching on there is dollar cost averaging, right?

Starting point is 00:53:07 you do lay out here in the book, I find this to be so fascinating because I do think this is a folly for most novice investors, which is, oh, it went down. Let me buy more and I'll dollar cost average my price down, right? That makes all kinds of sense. And in fact, it kind of ties back to a Warren Buffett value investing kind of approach because price is kind of what dictates everything with that style of investing. And obviously at a lower price, it's a better deal. But what data, if any, have you seen around the idea of actually cutting losses and adding to winners over time? Is there empirical evidence that that is actually a better strategy? Or is that just your experience from what you've seen with your own performance?

Starting point is 00:53:50 So one of my favorite market studies that was ever done was conducted by J.P. Morgan many, many years ago. And they looked at the prices of thousands of publicly traded stocks over a 30-year period. And what that study concluded was about 40% of stocks that are on the public markets will fall 70% or more and stay down permanently. They put their investors to a huge economic loss. About 25% of companies will underperform the market over time but won't do that bad. So they'll just be trail behind the market. Another 20%, 30% or so of companies will actually do better than the market in general, but just barely. And about 10%, 7 to 10% of companies, depending on the industry that you're in, those stocks

Starting point is 00:54:35 will go up so much that they literally cover all of the losses of the other companies and drive the entire market higher. Now, what of those companies' stocks have in common? What are those mega winners have in common? Well, their stocks were already up huge and they continued to win. And what are those stocks that lost in the market badly have in common? Their stocks went down and then continued to. go down. So again, this is such a counterintuitive lesson that I had to learn the hard way. And that

Starting point is 00:55:04 lesson is winners tend to keep on winning and losers tend to keep on losing. Is there exceptions? Of course, this is investing. There's always exceptions to every rule. But broadly speaking, if you showed me 10 companies that stocks were going up, 10 companies stocks were going down and said, pick your horse, I would pick the ones that were already going up. Okay. So one of the reasons I think people should buy this book is, especially if you're just starting out, is not only for all the basic material that we just kind of covered and if you're just getting started investing, but at the end of the book, you do go into a lot of actionable items, meaning things such as, where do I buy stocks, how do I set up an account? Which account should I set up, et cetera,

Starting point is 00:55:45 et cetera. So it's very actionable, very helpful. We aren't going to get into that today. But one thing that stood out to me was, again, one of those things that has been around forever in my mind, And I've just never questioned, which was the 401K. And you mentioned earlier in this interview that the 401K came about almost as like a mistake, I believe, or some kind of circumstantial thing. And now it's around and continues to be around. So walk us through the story behind the 401k and how it came to be. So a quick little side story.

Starting point is 00:56:14 When I was in, I think, middle school, I had to interview my dad about what he did and his benefits and all that kind of stuff. And as I was doing that, he said, well, I have a 401k. And in my mind, I was like, does that mean you make $401,000 per year? Like, is that your, is that your salary? Because it's such a weird thing to call it, right? A 401k. But if you look at the history of the 401k, you understand why it was labeled that. And what I love about the story of the creation of it, it was an accident that the 401k was created. So in 1978, Congress made some big changes to the U.S. tax code. And those changes went into effect a few years later. Now, an eagle-eyed benefits. attorney named Ted Banna was reading through the changes and looked at Section 401k of the changes. And he noted that employees could now, because of the tax changes, defer taxes on income that was invested in the stock market. That seems like a very small change that Congress just overlooked when it threw in there. But what Banner realized and surmised is that the language was vague enough that it

Starting point is 00:57:20 could be applied to thrift saving plans. So now, because of tax code change 401k, you could combine the pre-tax profit-sharing plans, the benefits of a pre-tax profit sharing plan with the employer match of a thrift plan. So Bena actually went to his own company and convinced them to launch essentially the world's first 401k. And it gradually caught on. And today, it's the number one way that Americans save for retirement. And as of June of last year, there were $7.3 trillion in 401k accounts. But it's all thanks to this benefits attorney that notice that the language was vague enough and convinced his own employer to set one up. And if you're one of those listeners out there that is sitting back and made it through this far and says, you know what? None of this applies

Starting point is 00:58:12 to me because I have a 401k at my work and I don't have to think about any of this. then I would say, well, why are you listening to the show? But also, you should be advised on this mistake that I wasn't aware of, but you bring it up in the book around 401Ks and how often a lot of people think their money is being invested in a 401k when in fact it's not. So what is going on there? Yeah, if you talk to somebody that isn't very fluent in finance, they've heard terms like 401K, IRA and Roth, etc.

Starting point is 00:58:40 And they think that that is an investment choice that you can make. So they say things like, oh, I have a Roth or oh, I have an IRA, as if buying this thing called Roth automatically makes you invested in the market. In truth, 401Ks, Roth, IRAs, those are all just wrappers around an account that provide that account with some specialized tax treatment. So one big mistake that could potentially be a multimillion dollar mistake is they sign up for an IRA or a 401K. They fund the account with money, but they don't take the next step, which is actually investing

Starting point is 00:59:14 that money into the stock market. Now, some accounts make that process very simply and even do that for you automatically. But just because you set up an IRA or Roth doesn't mean that you're invested in the market. So if you're going to do that, please double check to make sure that the money is invested and not just sitting there in a cash account. All right, Brian, well, this was a lot of fun. The book is called Why Does the Stock Market Go Up? I love not only that this book was written, but that you wrote this book because you have this amazing ability to break things down to the absolute brass tax, so to speak, of what the topic is at hand. It's a very easy read. I recommend it to everybody, even if you're an experienced investor. Before I let you go, tell people where they

Starting point is 00:59:57 can find you, where they can find the book, any other resources you want to share. So the book is officially launched on April 5th, and it's available at all the major places, especially Amazon. But if you want to connect with me personally, I'm most active on Twitter. Twitter, and that's at Brian Faroldi. I also have a YouTube channel. That's my name, but I'm on all the social platforms under my name. Congratulations, Brian. Thanks a lot for coming back on the show. It's always a pleasure. It's right. It was awesome to be here. Thank you so much for having me. All right, everybody, that's all we had for you this week. If you're loving the show, be sure to follow us on your favorite podcast app. Be sure to come visit us in Omaha at the Berkshire Hathaway meeting.

Starting point is 01:00:34 Get in touch with me on Twitter at Trey Lockerbie. That's where Brian and I originally met. and absolutely do not miss out on all the resources we have for you at the investorspodcast.com. So with that, we'll see you again next time. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional

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We Study Billionaires - The Investor’s Podcast Network - TIP437: Why Does The Stock Market Go Up? w/ Brian Feroldi

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