How Does The Stock Market Make Money?

Instead of a company, let’s talk about the stock market more broadly.

You know it’s a place where people trade shares in companies. You know that if you bought Apple back when it almost went bust you would be stinking filthy rich.

But what’s the best way for normal people, people who can’t spend all day researching Apple and Google, to make money in the stock market? What are you even doing when you get involved with the stock market?

stock market dollar into binary

Image: Famzoo Staff

The dog story

Every morning, Joshua takes his dog Boris for a walk in the park. Boris is exceedingly excited, and as soon as they get there, runs 50 feet to a random tree, and then sprints 30 feet sniff another dog’s bits.

To a casual observer, Boris is all over the place.

However, Joshua knows exactly where he is going. He is doing a triangle of the park from the entrance, to the bandstand, to the coffee shop and back out again.

Deep down, Boris knows where he is going to end up too.

The average return on the equities is 7% a year. It goes up and down, but this 7% is the statistic you should focus on.

Supposedly.

This story is an actual marketing anecdote by a professional Fund Manager. It is comforting, and when Boris and the stock market are up, you are going to feel rather good about yourself.

However, when it is down and Boris is biting you on the ass, you are not going to enjoy it.

Little workmen

Ultimately you want to save enough money so you can live a life of luxury and stop working.

The median earnings in the UK in 2015 was estimated at £27,600, or $40k. In the United States it is nearer $45k.

As the $40k is easier to use, I’m going to run with that. The 10 year US Government bond yield is about 2%.

When you save and invest $2m in US bonds, you have something that earns $40k or 1x median earnings, every year.

This is abysmal. About 2 years ago bond yields were 3%, so the work of one person then was equivalent to $1.3m. 5 years ago it was $1m.

Isn’t it great, you’re worth more and more!

Wrong, unfortunately. What’s happening is its getting harder and harder for you to retire early. For you to have a decent pension even if you retire late.

However this is putting your little workmen to the least risky work possible. The US Government is not going to go bust.

Putting your money in bonds is putting your workmen in the ultra-safe civil service. They are probably sitting at their desk with a hard hat on.

how does bob the builder make money

Image: JD Hancock

That’s where the stock market comes in. What if you decide to send your work men behind the counters at HSBC? Or to Silicon Valley to spend some time at Facebook?

Then they can earn you more.

But it’s risky. Maybe you think you’re putting them to work for Facebook, but actually you’ve sent them to a copper mine in Papua New Guinea. Its back breaking work and all it takes is some fun and games with dynamite and your little workmen come back with only one leg.

Capital vs Labor

JP Morgan did a study on the so called “sharing economy”. They were able to look at their customers’ accounts and track if they were receiving money from the various platforms like AirBnB, Uber or Taskrabbit.

Clearly, on Uber and Taskrabbit, you are selling time, while on AirBnB you are retailing your roof.

The study found that platforms like AirBnB generated modestly more income. It confirmed that platforms that monetize an asset tends to be additional income, whereas Uber, where you are selling your time, was more likely to be your only source of income.

Although there are only 24 hours in the day, for both labor and capital, its much easier to put more money to work than it is to grow another pair of arms.

Putting your guys to work

This is what saving is. It is to substitute or complement your labor, your arms and legs, with cash. When you sign up to Etrade and put money into the stock market, you are renting the arms, machines, and managers of the companies you are investing in.

You are taking a risk.

There’s only one free lunch when it comes to investing, and that is diversification.

Effectively, instead of renting one person, who is more than capable of getting hit by a car. You are renting the pinky fingers of a hundred men and women, significantly decreasing the risk you are taking.

Warren Buffet recommends that the average person keeps 10% of their assets in cash, for rainy days, and the rest in a passive stock market tracker.

This is to take advantage of diversification, and to avoid the fees asset management companies might like to charge you.

Personally I don’t think there’s anything wrong with 10% in cash, 20-30% in a few stocks you really like and the rest in a passive stock market tracker or Exchange Traded Fund (ETF).

This website is all about giving you some insights into some of the more interesting businesses in the world like Yelp and Groupon. If you understand what a company is really about, then you are much more likely to have the best guys and gals working on your behalf.

Ironically I do happen to prefer Gold over all else in 2016!

 

 

Yuen Lo

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