This is the second of a ten part series similar to what I did with “The Biggest Myths in Economics”. Many of these will be familiar to regular readers, but I hope to consolidate them when I am done to make for easier reading. I hope you enjoy and please don’t forget to use the forum for feedback, questions, angry ranting or adding myths that you think are important.
Myth #2 – The Stock Market Is Where You Get Rich
Today’s stock market often resembles something closer to a casino than a place to allocate your assets. There’s an endless number of TV shows reporting short-term gains in stocks and telling stories about people who got rich trading their accounts. The problem is, these stories are usually outliers that apply to a lucky few coin flippers while the vast majority of people trying to trade their stock accounts to riches are perennial underperformers.¹ But there’s something more fundamental going on here so let me see if I can explain.
As I explained in Myth # 1, when you buy shares of stock on a secondary market you are not “investing” in the true economic sense of the word. That is, you’re not spending for future production. In fact, the firm whose production you’ve bought into doesn’t even care if you own the stock or if your neighbor owns the stock because they’ve already raised the capital (capital that can be spent for future production) by issuing the shares in the first place. What most of us do with these already issued shares is simply an allocation of unspent income. In other words, we’re actually just savers looking for various asset classes in which we can hold that savings to achieve various financial goals. The real “investors” are people who start businesses and actually allocate capital for the purpose of generating future production. I hate to break it to you, but you’re most likely not an “investor” when you buy stocks or bonds.
This is important to understand because it’s rather backwards to view the purchase of stocks on a secondary market as the place where you “get rich” or where you “invest”. On average, the stock market generates a real, real return (that’s the after taxes, fees and inflation return, ie, the “in your actual pocket” return) of about 6.75% over the long-term. So, if you’re a young aspiring “investor” who allocates, say, $10,000 to the S&P 500 at the age of 25 you can expect to have a whopping $70,000 or so after 30 years (assuming no further contributions of course). Not exactly the “get rich” plan you thought, eh? But that’s the idea that is continually pounded into our heads through various media sources – this myth that the stock market is somewhere where you get rich. The reality is exactly backwards. Most of the time what you’re buying when you buy stocks on a secondary exchange is a claim on assets that made SOMEONE ELSE rich.
Let’s put this into some more realistic perspective. For instance, let’s take a look at a bond because that’s a very simple product. So, a bond that matures in 10 years and yields 2% will generate an annual return of 2% per year. Of course, that bond’s price will fluctuate as traders try to guess what the present value of its future cash flows are, but the initial math is still consistent – that bond cannot pay more than 2% per year on average over its 10 year lifetime. You can try to time that instrument and guess when it’s undervalued or overvalued, but you can’t change the fact that it is an instrument that can only pay out 2% per year. Unfortunately, we know that guessing the “value” of these instruments can be very difficult. The annual SPIVA report cards show that active investors have about a 13% chance of consistently achieving this.² So it’s not impossible, but the odds are stacked heavily against you. The stock market is even less predictable than the bond market so while it pays a higher annual coupon on average, it is still incredibly difficult to consistently “beat the market”.
At a more operational level, the stock market isn’t the place where you get rich in the first place. You see, when shares are issued on a secondary market they’re being issued by companies that have to meet extremely stringent listing requirements. And by the time any corporation has grown to the point that they’ve met these listing requirements they’ve likely established a business and source of output that is extremely valuable. “Going public” and listing their shares on an exchange like the NYSE gives the firm access to funding, but it also gives the owners an exit from what was their real investment (most owners actually fronted capital for real investment spending and later sell their shares to you as they reallocate their savings). These owners spent for future production (made real investments by building a productive asset) and are likely exiting from their investment on the secondary market. In other words, you’re allocating your savings into what was really someone else’s investment. And there’s virtually no doubt that by the time the firm has achieved the growth necessary to be listed on a major public secondary market that its owners are fabulously wealthy. If you don’t believe me just have a look at the Forbes 400 wealthiest – the vast majority of those people didn’t get rich picking stocks. They built companies, built real goods and services over a long period of time and the only reason you likely even know what the firm is or who runs it is because they’ve already built something valuable.
Now, this doesn’t mean it’s impossible to become wealthy picking stocks on a secondary market. There will always be people who “beat the market” and ride stocks to riches. In fact, most of the people who get rich from the stock market will be famous fund managers who went on a hot streak and benefited from investors chasing their “hot hand”. They are, more often than not, rich because they marketed their high fee business to people who were silly enough to chase their past returns and not because they have a crystal ball about the future. And their wealth usually comes out of your pocket as opposed to being the result of some sort of “market beating” strategy.
But that’s not the point of this story. The point is, in the aggregate, the market returns the market return and the market return isn’t likely to make investors rich quickly in the aggregate. In fact, you’re almost certainly buying an asset that has already made someone else rich well before you ever had the opportunity to own a claim on that asset’s cash flows. This doesn’t mean that buying stocks and bonds is bad. It doesn’t even mean you can’t “beat the market”, but we should be careful about the concept of “investing” and how it actually leads to us becoming wealthy. You’re much more likely to become wealthy investing in your own ability to generate future production than you are by buying an asset that was actually someone else’s “investment”.
¹ – See, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, by Barber and Odean
² – See, 2016 Annual SPIVA report card by S&P
Did you have a comment or question about this post, finance, economics or your love life? Feel free to use the discussion forum here to continue the discussion.*
*We take no responsibility for bad relationship advice.