What Everyone Should Know About the Stock Market

By Phil Mackintosh, Chief Economist, Nasdaq

During the pandemic we have seen a significant increase in retail activity in the stock market.

Main Street investors are good for stocks

Phil Mackintosh, Nasdaq

The entrant of new, Main Street investors into the stock market is mostly good. Data shows that around 45% of U.S. households still have no exposure to the stock market. Despite that, Federal Reserve data shows direct ownership of stocks is even higher than mutual fund ownership. That makes individual (direct) investment a significant source of capital for U.S. firms.

Fed data also shows that many low income households are overinvested in housing and bonds. Over the long term, stock performance beats residential real estate and fixed income. That means increased retail ownership of stocks should improve the retirement security of more households, as asset diversification reduces volatility and improves overall returns.

Chart 1: Households are already the biggest owner of stocks

Also, stocks with higher Main Street participation (purple stocks below) seem to have higher liquidity. That tends to reduce trading costs for all investors and lower the cost of capital for companies.

Chart 2: Households appear to boost liquidity too

So there are good economic reasons to encourage these new entrants into the stock market.

Understand how stocks work

Given that, it is important that these new investors generate positive long-term returns so they remain invested in stocks. Since stocks are not “risk free” assets, this requires many new investors becoming more familiar with markets.

The good news is that there are plenty of resources for new investors online, including Nasdaq’s own page on smart investing. There you will find information on some important principles of investing—from how diversification can help reduce risks to how ETFs and options work.

We can also highlight the most important things for individual investors to know as they become more involved in the stock market.

Five things everyone should know about the stock market

  1. Stock markets have a lot of transparency and information for investors

Although stocks are not risk-free, they are more transparent and considered less volatile over the long term than many other investments.

Compared to other markets, stock markets are well regulated with transparent company accounting and auditors. Investors can gather a significant understanding about the financial performance and stability of any listed company.

Trading rules also require all investors see the public exchange prices from all buyers and sellers. That in turn ensures investors get the best prices on trades and receive best execution services from their brokers.

Chart 3: Stocks and ETFs lay in the middle of the risk spectrum

  1. Stocks can go down; diversification can help

Stocks go up AND down. Diversification is what professionals use to weather the storms.

Some of the shares you buy will rally, or pay good dividends, or both. While others might not even return your initial investment to you, even after many years.

Stock prices can fall if company profitability falters. Some companies will even file for bankruptcy, and they usually return no money to stock holders. That’s why financial statements showing company balance sheet stability and profitability is so important.

Diversification is a tool used by professional investors to minimize that risk. Buying more than one stock reduces the impact on your portfolio from stocks that rise but also those that fall. Importantly, it reduces the likelihood that you will lose all of your savings. Done right it can also expose you to gain from different parts of economic cycles. Commodities, tech and healthcare stocks all tend to gain during different times in the economic cycle.

Usually diversification also reduces the volatility of your whole portfolio. This can be seen in the example in Chart 4, which tracks two real stocks in 2020. Both stocks were doing well before COVID-19 struck the market in March. Even though Stock A’s price fell more than 60% thanks to the impact of the Coronavirus on its business, it saw days with large gains. In contrast, Stock Z benefitted from changes caused by the pandemic, more than doubling, but still saw some days with significant falls. But as a portfolio, some of the down days offset, reducing overall portfolio variability (technically called volatility) and also outperformed.

Chart 4: Buying a diversified portfolio of stocks reduces risk

One of the easiest ways to build a diversified portfolio is to buy exchange-traded funds (ETFs). Almost all ETFs represent an already diversified portfolio of stocks. They may hold a collection of tech stocks, small cap stocks or even bonds.

  1. Earnings drive valuations

At the end of the day, shares represent a part ownership in the value of a business. That valuation in turn is driven by current earnings and expected future earnings growth. In fact, a recent study by Bank of America found that over the long term, earnings explains around 80% of stock price performance.

The importance of earnings to company valuation is one of the reasons that financial statements showing company profitability and historic growth are so important. It’s also why a lot of investors look at the Price-to-Earnings (PE) ratio and might say that stocks with a high PE ratio are “rich.” But sometimes those high PE ratios will be justified by a company’s strong future earnings. Investors need to determine if growth forecasts are accurate.

Chart 5: Actual and expected earnings drive stock valuations

Interest rates also affect company valuations. Low interest rates make it easier for companies to grow faster than the economy. The current near-zero interest rates are one reason used to justify the fact that share prices have gained much more than company earnings in the past decade.

  1. Economies can go up and down, and that affects companies

Even with a diversified portfolio, the whole market can be dragged down by a slowing economy (or a pandemic). Chart 6 shows that often these “bear markets” can last longer than a year, and diversified portfolios can fall well over 20%.

When that happens, it’s often important to be able to wait for the economy (and stocks) to recover. Bear markets often represent good buying opportunities, as stocks are cheap. Experts advise not to wait for the economic data to show the economy has started to recover, as markets are also usually better at forecasting the end of recessions and typically lead the recovery in real economic data.

Chart 6: Economies can drag whole markets down too, sometimes a lot

The economy can also affect market-wide earnings. Recessions usually cause sales to fall, which reduces profitability. That in turn leads to some job losses which cause sales to fall further.

Because of the feedback loop that these pressures can create, governments often act to limit recessions by reducing interest rates, which lowers costs, or increasing government stimulus, which increases revenues. Both these actions can improve the balance sheets and profitability of companies.

  1. Not all trading is free

It’s easy these days to think that stock trading is free. Trading costs have certainly compressed to just a fraction of prices paid for stocks, with many popular retail trading services bringing their commissions down to zero. But not all costs are commissions.

All buyers would like to buy (bid) for less than sellers would like to sell (offer). The difference between these bid and offer prices is called the spread. When you buy or sell a stock with a market order, you also cross a spread. For many liquid stocks, spreads are fractions of a percent. But some smaller or less-traded stocks can have wider spreads, and possibly not enough shares. When that happens, market orders may trade at even higher prices too, until there are enough sellers to match your order size.

Crossing spreads increases the price you pay for a stock. For those trading frequently, the costs of crossing spreads can add up.

In contrast, investors using limit prices to join other buyers at the bid will need to wait in line for a seller to trade with them. Sometimes a more urgent buyer will instead lift the offer and you’ll need to increase the price you need to pay to remain in the market. Sometimes it can cost even more than buying the stock at the offer in the first place.

There may be other less explicit costs too, like different interest rates for cash balances than loans, management fees for ETFs, or financing and hedging costs included in options prices.

Trading may be easy, but successful investing is hard

It’s important to remember that stock markets are filled with many sophisticated and experienced investors. That often works in Main Street investors’ favor, as it means assets are reasonably accurately priced and spread costs are low. But the fact that even professionals have to work hard to beat the market should limit the expectations for new investors.

For example, a recent study found that professional traders were less likely to cause price bubbles, and understood trading strategies better. Other studies have found that individual investors often trade too much, or at the wrong times in the cycle, harming their returns.

The reality is that although investing is easy to do, it is hard to do well. We welcome new investors to the market, but encourage them to use the resources available to avoid common investing pitfalls. If we can do that, the U.S. equity market will be more vibrant and more liquid as a result.

And as a reminder, you can start right here.

What every investor should know about the stock market was originally published by Nasdaq.

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