The Dot Com Bubble, The Tulip Bulb Crisis, The Market Crash of 2008, And The Market Crash of 2020, Bubble Mania In The 20th and 21st Centuries
As I sit here on this typical winter day in Southwest Florida, writing the original copy of this manuscript, it becomes apparent to me that I am writing this book for the every man, for the truck driver, the maintenance worker, the plumber (not that there’s anything wrong with plumbers….more power to them) the computer programmer, and for all those people of different specializations out there who might not have had access to, or the care to, learn all they can about finance-this book is for you. I wanted to make a no bs, straight to the point financial novel that tells you everything that you’ll ever need to know about finance, all in one place. If you’ve gone ahead and taken the plunge and decided to buy this book, first of all thank you (and my Traditional IRA thanks you too…more on the importance of one of those later in the book), and second of all, I hope that you can keep this book as a kind of reference, a guide that you look to each and every time you look towards making an investment decision, or a large purchase, or any decision that is a crucial one involving money. If you read this book, understand its concepts, read thoroughly the charts and spreadsheets that I have included within the book, and strive to grasp the awesome power of compound interest, and the time value of money examples that I have outlined within, you will have a firm grasp on how you can plan for your retirement, and of how you can live far below your means now, so that you can live in relative financial bliss later in life. The following work will look at the dot com bubble, bubble mania, and is an excerpt from my future book, enjoy the post, and subscribe for regular information updates!
The Dot Com Bubble vs The Tulip Bulb Crisis vs The Market Crash of 2008
The knowledge and information contained in this novel comes from the knowledge I’ve accumulated from my B.A. in Finance from FGCU, and from thousands of hours spent sitting in a classroom, listening to some of the best finance professors in the world. I’d like to take the time to thank especially my teachers, Dr. Stephen P. Frasier, Dr. Travis Jones, Professor Alejandro Figares, Professor Michael Zahaby, and Professor Thomas Matthews CFA, for really giving me a firm grasp on the subject of finance, and for pushing me to my limits during my time of study at FGCU. The knowledge that you guys have given me through your PHD’s, college degrees, real world experience in banking and investments, and general life experience will be forever with me, and for that I am eternally grateful. Much of the info in this book is also comparable to the novels “A Random Walk on Wall Street,” by Burton Malkiel, which I highly recommend as a good read, and from Dave Ramsey’s podcast and novel, these men are multi-millionaires, with Dave Ramsey being a decamillionaire worth over $50,000,000.00, and their common-sense financial knowledge is absolutely second to none. I hope that this novel and financial handbook will turn out to be as useful and interesting for you as my study of money management has been for me, and for more information, be sure to check out and subscribe to my blog, there’s tons of great, free information on there as well, and I know that if you like this book, that you’ll find that interesting and useful. Enjoy the book and good luck!
Chapter 1 – INTRODUCTION To The Dot Com Bubble
I’ll keep my opening chapter introduction to this book as short and sweet as I know how to. This book will encompass just about every single major thing that you’ll ever need to know about finance, including how to sort through the noise of what CNBC or Bloomberg is telling you on your 42” flat screen TV while you’re having your morning coffee, why you shouldn’t day trade, why retirement accounts are your best friend, and why simple arithmetic tells you that you should start investing as young as possible, and a whole lot more. While you may hear that among the professionals on Wall Street, and in comparison to super-genius quantitative analysts, that trading or investing as well as the professionals is next to impossible, this is simply not true, and in fact, by doing nothing more than holding a passively managed index fund with the lowest fees possible, you can more often than not beat the returns that you would get had you put your money with a professional.
While such a feat might sound somewhat outlandish now, throughout this book I’ll take you through why it actually isn’t, and why the game of finance is just that, a game that is by far and away made to generate sales and commissions for the overzealous brokerage firms, more than it is to generate a solid rate of return for the investor. Make no mistake about it, aside from a handful of extreme outliers, and I do mean a handful (like probably less than 1-500 people on this planet) are able to beat the market consistently year over year. This is not to say that it doesn’t happen occasionally, or that there aren’t huge swings of luck such as those apparent in notorious bubbles like the Tulip-Bulb Craze or the “Tronics” bubble, or that the volatile swings of luck and fortune don’t occasionally fall into the hands of some poor sap that has no clue what to do with it, in fact just the opposite.
The general premise of this book is going to be for you, as the investor, to preserve as much of your wealth as possible, to understand the stock market in ways that the layman that isn’t conscientious enough to read a handful of basic finance books can’t, to move past your own, pre-programmed genetic biases that all humans inherently have, and to make the smart decision when investing, whether it be in equities, in real estate, or in as something as simple as CDs, treasury bills and retirement accounts. This is not a get rich quick, or a day trading book, for more information on those types of strategies, be sure to look at my blog (more information on this will be in the appendix and the conclusion, at the time of me writing this book I haven’t actually gotten it set up yet….) and likely my future Youtube channel. For now, though, this will serve as the most basic, easy to read personal finance book that I know how to write.
A little bit about my qualifications, and why I feel that I am knowledgeable enough in the subject of finance in order to give you the work-around on what’s what in the market, and for how I think you should invest your assets. I am a graduate of Florida Gulf Coast University with a Bachelor’s Degree in Finance, and have been taught by some of the best finance guys in the world there through my time of study with the school, including 2 CFO’s of multi-billion dollar banks, active fixed-income traders, guys who used to work on Wall Street, Doctorate’s of Finance, and overall just some really smart, experienced people. I have also, as of writing this book, previously built an internet company that made six-figures and am currently a Financial and User Acquisitions Analyst at a $300,000,000.00 valued internet company down in Southwest Florida.
What Warren Buffett Says About Market Crashes
I have also read dozens and dozens of books about Finance, including classics like Warren Buffets biography, Burton Malkiel’s “A Random Walk on Wall Street,” “The Intelligent Investor,” by Benjamin Graham, “Security Analysis,” by Benjamin Graham, Peter Lynch’s investing book, and novels on the derivatives markets, options, technical analysis factors, financial statement analysis, and the like. I am also currently in the works of building up a Finance blog in order to expand others financial knowledge, as well as my own, and in doing the same with a personal-finance based Youtube channel. While there are undoubtedly people out there with better qualifications than this, who would no doubt write a more complex book than me on this subject, I think that my qualifications and knowledge listed above give me enough credibility to write a sort of “Layman’s Guide to Finance,” and to talk about it to those who are lacking in their education of managing money, tax avoidance, the use of retirement accounts, how they can read the stock market, what information is useful and what isn’t, and the like.
I am writing this book for the every man, the grandmother who is struggling to manage her portfolio and get her finances in order, the college student who is struggling to manage their finances and get their spending under control, unsure of what to do with equities and of how not to get emotional with regards to playing the stock market, and the stay at home mom who is pushing 40 years of age, and is still ignorant to what a Roth IRA is (not hammering you at all ma’am if you’re reading this….just saying that this book is for you). I think that I have knowledge enough to teach you the ins and outs of finance, and to make you a “financial guru” of sorts among the uneducated masses. After reading this book you should have a much more thorough understanding of how to cut through the noise and function in the equity markets, of how to invest and of how much risk to take on based on your age, of how to read Bloomberg and CNBC and analyze a company effectively, and the like of these other issues that come up among those that have not had much financial exposure. I hope that you’ll have as much fun and will gain as much from reading this book as I will from writing it, in the next chapter, we’ll look at a brief history of the stock market, of why bubbles happen, and of why they are doomed to repeat themselves again and again. I urge you to read each chapter thoroughly, and beyond that, to keep this book at home for the future, to use as a guide for each major future financial decision that you embark on. Enjoy the book and feel free to contact my blog with any questions (contact information in the appendix.)
Chapter 2, A Brief History of the Stock Market, Mass Psychology, and Bubble Mania, Comparing The Dot Com Bubble to Other Popular Crises Throughout History
Let’s begin our journey into the world of high finance by looking into group think, mass psychology, and the main history of bubbles, and of how they have proved treacherous to the long run rate of return of the investor. Over the long term, they are poison, and the general advice throughout this book is going to be for you to stay as far away from the speculative positions that your friends or co-workers may take in times of extreme inflation and overblown prices in the stock market (no matter how much money they make, or claim that they have made) as possible, in favor of the disciplined investing strategy that we outline for you in this book, which is essentially just holding a well-diversified, passively managed index fund commensurate with your risk tolerance, and never (or rarely and with few exceptions) deviating from that path.
Ever since the first issue of shares to the public by the Dutch East India Company, the world’s first real IPO (stands for initial public offering, this denotes the first time that shares are offered for sale to the general public on the secondary stock market), in 1602, crowds, bubbles, and “irrational exuberance” have been ever-present in the stock market, and have driven stock prices to speculated values that were far higher than those of what they were actually worth. This chapter will stick to a few of the main bubbles throughout history, including The South Sea Bubble, The Tulip Bulb Craze, The Dot Com Bubble of the early 21st century, and the Mortgage Crisis and Housing Bubble of 2007, 2008 and 2009. Through this brief history lesson, you will see that the natural human tendency is wishful thinking, and that except in a minority of instances, these bubbles prove more disastrous to the speculative investor than fortunate, as market timing is next to impossible, and in fact diversification is really the only long term solution to the wild ups and downs of the near totally-efficient stock market.
The Tulip-Bulb Craze
The essential bulk of the Tulip-Bulb craze took place from 1634-1637 in Holland. At its peak, you could trade a rare Tulip (which today, and throughout the majority of history, has been a $1 flower…. or whatever it costs right now) for an entire house, and at its bottom, for what was the price of a 17th century onion. The Tulip-Bulb craze is important to understand because it is one of the main, and first bubbles that took place in human history, and took place even before the inception of the first stock was created by the Dutch East India Company in 1602. Through the magic of what was basically a prehistoric futures contract, Tulip Bulbs, a simple flower, would rise to extraordinary prices, completely irrespective of what the real value of the item was. There is a saying in Latin that goes something like
Res tantum valet quantum vendi potest
Or “a thing is only worth what someone else will pay for it,” which I think perfectly sums up the issues and psychological forces that drove the highs and lows of the Tulip-Bulb Craze, as well as market bubbles in general. There is a common misconception out there by the investors who always end up getting screwed in the end, which is usually the speculative investor that succumbs to his or her more animal instincts when choosing an investment strategy. This misconception, at least with regard to bubbles, is that you can ride the bubble on the way up, and take your profits at the top, or near the top. The problem with this misconception, is that even if you are somehow able to time this even close to correctly, which is next to impossible and takes nothing but blind luck as far as I’m concerned, when you get to the top, no one is sitting there ready to buy your overpriced shares. As the saying goes, a person is perfectly willing to buy a $15 item for $30 if they can find someone who will pay $60 for it, the problem is, you eventually run out of “greater fools” as they are called, that will buy that item at that higher price. This was especially noteworthy during the dot com bubble, which will be discussed later in this chapter, many people had stocks in their portfolio that had appreciated during the height of the bubble, or that were absolutely bleeding out and falling to a worthless pile of nothing, but when they tried to either capitalize on their “bubble gains” as I call them, or sell out to stop the bleeding, there was no one out there that was still foolish enough to buy the stock at that overzealous price, this occurs more frequently on the way down, as the stock is bleeding out, which is a much worse position to be in, since everyone is selling the stock, and no one is buying.
Nonetheless, during the tulip-bulb craze, this exact same occurrence happened, and no matter how many different colored Tulips blossomed in an effort to inflate their already unwarranted price (the flowers during the early 1600’s had fell ill to a virus known as “Mosaic” which gave them flame-like stripes, they would later be called “bizarres”) eventually the market adjusted to the over-optimism and mis-priced tulips, and they would be worth next to nothing when it was all said and done. The price of these tulips were inflated by nothing more than mass-market speculation, as individuals believed that the price would continually go up, and that these were somehow valuable flowers, when all that was really happening was that individuals were speculating on 17th century call options (a form of leverage that will be discussed at a later point in this book) grossly over-inflating the market, and allowing the price of a simple flower to be worth as much as what your house is worth now, before dropping all the way to the price of a hand fruit, yes bubbles are that powerful.
The South Sea Bubble
The South Sea Bubble occurred in England in 1711 and involved mainly investments in securities packaged into the “South Sea Company.” During this time frame, The South Sea Company had been formed as a kind of IOU from the government to the citizens of the United Kingdom, to the tune of almost 10 million Euros (inflation adjusted about $700 billion USD present day). Around this time frame, the few companies that were actually offering stock for sale all had reasonable fundamentals (the actual financials of a company, their revenue, expenditures, profits, free cash flow, etc., as opposed to their technicals, which are comprised of things like mass psychology, chart patterns, historic prices, technical factors etc.) however, few were invested in them, and they were somewhat difficult to get your hands on, as they were typically only gifted to, or made accessible to, those wealthy individuals in the economy. As we know from basic economics, a combination of scarcity and novelty, blended with the widely known brands and good fortune that these companies had behind them, created what would eventually be an extreme hunger for them by the public, and would make “South Sea Company” shares, a big hit in the European market. Combine these factors together, and you have a stock that is ready to shoot through the roof, plain and simple. Not long after the emergence and success of the South Sea Company, a similar British company, known as “The Mississippi Company” was formed, and established in the country of France.
Over a few short years, the company’s stock price would eventually move from a price of 100 Euros per share, to more than 2000 Euros per share, not through fundamentals and increased company earnings, but instead through the irrationality of mass psychology, and through nothing else but the power of momentum present in that of a bubble. Burton Malkiel’s “Random Walk on Wall Street” added this data to the event, quoting that “At one time the inflated total market value of the stock of the Mississippi Company in France was more than eighty times that of all the gold and silver in the country” which is really a sight to behold, seeing as if during this time period, the monetary system was essentially based on gold and silver coins, and the premise of the Mississippi company was coined by John Law as “a way to replace metal as money and create liquidity through a national paper currency,” I smell a bubble indeed.
History wouldn’t end well for those investors who got caught up in the noise of the Mississippi Company, and in fact a bill would eventually be lobbied for by advocates of the company that backed the company’s idea to fund the entire national debt using the company’s money! This would push the company’s stock from 130 Euros to 300 Euros immediately after the announcement, before eventually moving to 400 Euros at the next issue, 550 Euros at the next issue a month later, and over 800 Euros by the end of the year. Eventually, the price would hit 1000 Euros per share, before topping out even higher, as prominent English politicians, as well as every single layman, layman’s friend, and layman’s neighbor, got a whiff of the stock, and began to bet the house on it. 2 years from its height, the stock would eventually plummet (in 1722) to the lowest it had been in more than 6 years, at a valuation of less than $80 per share! Here’s the chart of the British South Sea Company to prove it:
In order to further touch on what is happening here, I’d like to give you guys a quote from one of my smartest professors during my time of studying Finance in college, professor Thomas Matthews, as I remember this specific quote very clearly. The quote is “when Taxi Cab Drivers start talking about a stock, it’s time to get the hell out!” He mentioned this in class one day, saying that he was vacationing in New York and 2/3 of the cab drivers he got in the car with were talking about Bitcoin during the “Bitcoin mania,” and that from that moment forward he knew the thing was going to collapse….as if the fundamentals of it didn’t already tell him that (there were none.) He went on to further explain that if cab drivers are thinking about stock when they’re supposed to be driving the damn cab, then people are going to be getting to work later, there are going to be more accidents on the road, there will be more deaths, lost economic productivity and lost jobs, which will move people to sell their stock, which will drive stock prices down….not a bad analysis at all. It’s also a pretty darn good indicator that a bubble is afoot, because cab drivers are supposed to be driving the cab, not talking about stock, aside from the aforementioned analysis of the phenomenon.
Now I told this story because one of the major reasons that this specific bubble got out of control, was that random individuals who really had no business speculating on this type of a security, began to get involved, and purchase large amounts of what would eventually be these hyper-inflated, and worthless shares, they would then tell their friends and neighbors about it, who then would tell their friends and neighbors, which eventually allowed the press to get wind of the madness of the crowd, which caused the whole thing to spiral out of control and blow up like a huge “bubble” only to pop….just like a bubble does, just a short time later. It wasn’t long before the directors of the company would eventually realize that the price of their shares were extremely over-inflated, and before they would subsequently dump their shares – this would be picked up by the press, and like clockwork, the price of the stock plummeted to next to nothing. The prudent investor is wise to take note of history, and that of the madness of the South Sea Company in particular, in order to avoid making the same mistakes, and succumbing to the same biases and greediness in their own investing techniques in the future.
The Dot Com Bubble
The dot com bubble specifically is one of my favorites to write and talk about, as it is probably the one that I understand the most thoroughly given my time spent building and selling internet companies, talking with and negotiating with owners of internet companies, and buying and scaling internet companies (plus working for one of them like I currently do). Since this is the field I am most knowledgeable about when it’s all said and done (if I’m being totally honest like 50% of the reason at least that I’m writing this book is so that I can build up a Finance blog and sell it to customers just like I’ve done in the past with related products) this is likely the historic bubble that I’ll go into the most detail on.
During my time as a Finance student at FGCU, there was a rumor going around in what I believe was my Financial Policy class that one of our other previous Finance professors had lost like $400,000.00 or something during the dot com bubble, I guess, as the story was told, he had put his entire portfolio into some high Beta internet stock sometime around 2000, and it had then gone up to an unimaginable height, before beginning to crash, (a high Beta stock is just an extremely risky, highly volatile stock, this will be explained in further detail later on.) As it started to crash, everyone was selling out and dumping the stock, so no one was buying, and as such, it eventually became impossible to sell out your shares (even though it might seem like the stock market is just an all-knowing, complex computer system, which it sort of is, it is still a “market” after all, and you aren’t able to sell anything if no one is willing to buy it…. Res tantum valet quantum vendi potest). I guess he had waited for it to fall far enough down, thinking “it’ll just go back up eventually, and I don’t want to take the loss yet” while it just kept dropping and dropping, until he was past the point of no return, and there was absolutely no way of selling out the position. Whether or not this rumor is true is another story, I tend to believe that the premise is true but that the details are somewhat exaggerated, nevertheless though, it provides a decent opening summary for the tragedy that is the dot com bubble.
Beginning with just how bad the dot com bubble was for even well diversified investors (investors who held the market portfolio, or the S & P 500), to put this in perspective, the NASDAQ benchmark index lost about 78% of its value as it would fall from a high of $5046.86 to a low $1114.11. Even if you were holding a mutual fund comprised of all the stocks in the NASDAQ, a fairly common investing method, as right now the NASDAQ composite index contains more than 3300 companies, is a common benchmark for determining the health of the market, and has a greater trading volume than any other on the U.S. stock exchange, carrying out nearly 2 billion trades per day, a $1,000,000 portfolio would’ve been worth just $220,000, that’ll make you lose a night or two of sleep indeed.
While the NASDAQ would come back, and stronger, had you rode out the historic high and low of the dot com bubble and waited several years (keeping with our portfolio management technique that will be explained in greater detail in a later chapter of this book), had you speculated on high risk, individual dot com stocks, your money unfortunately, would not have come back. To illustrate this, let’s take a look at some of the most prominent companies of the era:
What this says, at least to me, is that even if you bought good companies with solid financials, that would eventually go on to recover and become total goliaths, such as those of Amazon, with its now $1800+ share price at the time of writing this, and nearly $1,000,000,000,000.00, that’s a $1 trillion valuation, the second largest company in the world, Priceline, or Yahoo.com, which would become $100 billion+ market cap companies, you still got crushed by the dot com bubble, at least in the short to moderate term. There’s a quote that was going around during this time speaking of Nortel Networks (third stock from the bottom in that chart) that said that had you bought Nortel in 2000 and sold it in 2001, $1000 would’ve been worth just over $40. Had you instead bought $1000 worth of Miller Lite, the beer not the stock, drank the beer and cashed in the aluminum for 5 cents a pop, you would’ve had $72, so the lesson there is, don’t invest…drink heavily. 😉
Make no mistake about it, there is more than a tiny bit of accuracy present in that quote, had you put $1,000,000 in Nortel Networks (which its P/E ratio, or its Price to Earnings ratio, the price of the stock in relation to its annual net income, was well over 100, when the typical P/E ratio of the market is historically 25, so I don’t know why you would’ve done that) it was worth just over $5000, as my CFA professor Thomas Matthews would’ve said on the matter, “talk about wanting to jump out a freaking window.” If this chart right here doesn’t demonstrate just how bad the dot com bubble was, then I don’t know what the heck will.
In looking at how terrifying this may’ve been to a technical analyst, or one who believes in charts and chart formations as actual knowledge of what a stock may or may not do, here is what he or she may have seen, and of how terrified they may have been:
And that’s just for the NASDAQ, a legitimate, educated investor, could’ve held that in a well-diversified passively managed index fund and still got his a$$ handed to him by nothing but the wild swings of a stock market bubble (yes they would’ve lost 78% from the peak…but it’s actually not as bad as it looked, what mainly happened was just the irrational capital gains were wiped out. If you look at the price trend, before the insane spike of the dot com bubble in 2000 and 2001, it actually only fell to its level that it was originally at before the hysteria, in 1999, before growing steadily following 2004 and beyond.) The lesson is, holding a portfolio that is well-diversified is the only way to go, as the rest of the stock market investing (speculating) and trading strategies, offer no long-term stability, and historically, always fail in comparison to a buy and hold strategy. Next, we’ll cover the most recent bubble, excluding Bitcoin, which once again, has the exact same elements as the dot com bubble, the tulip-bulb craze and the South Sea Company have, an “irrational exuberance” and a near-limitless amount of greed, and of assets backed by no actual value.
The Mortgage Crisis of 2007-2009 vs The Dot Com Bubble
The mortgage crisis, which started in the years ranging from 2007-2009 (and the effects of which lasted through nearly 2014 as some economists would argue) was one of the worst bubbles, and likely the worst housing bubble (only the Florida housing crisis of the late 20’s even comes close) of all time. Through pure greed, a lack of due-diligence, and problems with the fed and the way that MBS products (Mortgage-Backed Securities) such as CDO’s (Collateralized Debt Obligations) were regulated, investors lost trillions in real estate value, as looser lending standards led to inflated housing prices, before rising default rates would eventually cause the entire bubble to finally pop.
The mortgage crisis is, in more ways than one, somewhat more difficult to understand than a lot of the other bubbles described in this chapter, in that it involves a series of high finance derivatives (arbitrary, made up securities that are priced based on the value of an underlying asset), a lot of issues with the federal reserve and the U.S. Government, and extreme corruption at the hands of lenders, due diligence, and the big banks. I’ll try to keep this section as brief as possible, essentially what happened, was the CDO was coined, the Collateralized Debt Obligation, which is just a fancy name for a mortgage backed security, or a security that is created that moves up or down in price as a function of the underlying asset, which in this case is a mortgage (with serves as what is essentially collateral for the bond, or CDO). Since the inception of the CDO, the derivatives market grew to more than 20 times the size of the actual mortgages that it represented, and while it is common of the derivatives market to be larger than the underlying asset that it represents, 20 times bigger is a recipe for disaster. As home prices continued to skyrocket from the increasing popularity of mortgages, one of the largest bubbles in our nation’s history formed. Defaults on mortgages would eventually rise to well over 8%, and with this, the supposedly investment grade bonds (defined as being rated as a BBB or higher) that were fraudulently over-rated by the rating agencies, who did so in an effort to get enormous fees from the banks, would eventually collapse. No underlying bond, derivatives become worthless, and you have trillions of dollars of wealth that wasn’t there in the first place, that evaporates practically overnight.
What each one of these bubbles tells us, is to not get caught up in the noise and the speculation, whether its tulip bulbs, tech stocks, Bitcoin, overpriced houses, or whatever the new hot bubble is, they are rampant throughout history, and no doubt there will be more and more to come over the years. In the next chapter, I’ll show you the foolproof method for how you can weather the storm of bubbles, through the only real, stable way to invest and reap a stable rate of return from the market overall, which is buying and holding a well-diversified portfolio with the lowest fees possible.
Chapter 3 – Why Competing with a Passively Managed Index Fund, with its Typical 10% Annual Return, is Next to Impossible, and Why You Should Diversify
So, I’ve mentioned a decent amount of times now throughout this book that I think your best bet over the long term (I’m not talking this week, next week, next year, or even necessarily five years from now, but like 20-50+ years from now) is to buy and hold the market, or better yet, an index fund, consisting of all the stocks in the market. This can be an S and P 500 index fund, this can be a Total Market Index fund etc. just needs to be something with the lowest fees possible, as these can drastically eat into your long run returns, that is well diversified. I’ll get more into what specific types of diversified index funds later on in this book, but first I want to look into some of the reasons why.
Over the last 100+ years, the U.S. stock market, the S and P 500, and the stock market as a whole (consisting of all the stocks in the market, foreign or otherwise) has given a 10% annual rate of return year over year. If you look at the math behind why exactly this is very high, and why this is just about impossible to compete with over a long term basis, such as the 25-50 year time frames of which this 10% annual rate of return holds up (anything less than about 20-25 years will likely be different than a 10% annual rate of return, as the stock market is volatile, not a straight line up, it’s up 11% one year, down 20% the next, then up 15% the next 3 years, etc. it’s not just 10,10,10, though wouldn’t that be nice) you can see that the multiple that you get on your money from having it in equities is absolutely unprecedented. To illustrate this, imagine that at the age of 23, you were gifted an inheritance of $40,000 for graduating from college with your B.A. in Finance, it was put into a Roth IRA for you and allowed to grow tax free. Being the smart and savvy Finance student that you are, you know that if you pull the money out of your IRA before you are 59 ½ years old, that you will be assessed a 10% tax penalty, and will have to pay the ordinary tax rate on your capital gains, so you leave it in and allow it to accrue interest until the age you want to retire, and until you start receiving your first social security checks (not that social security will likely be around by the time you’re 65 if you’re 23 right now….but that’s beside the point).
Off the top of my head, the rule of 72 says that, had you put this into an S and P 500 index fund, which has had a historic return of 10% annually over time, that it should double every 7.2 years (you take 72/interest rate to get the amount of time it takes to double. There’s a limit to how often this works, I think it stops working at like over a 14% interest rate or something like that, but I think it should get pretty close for this example). Given that you have had the $40,000 accumulating in your Roth IRA for exactly 42 years in this example, that should be just under 6 doubles, or about $2,560,000. When I do this same calculation on my iPhone calculator, I get $2,190,547.97, so it’s not quite $2.6 million dollars, but I was darn close (this assumes annual compounding.)
Regardless of how close my mental math was, this formula amazingly demonstrates how you can maximize your income and principal through the amazing power of compound interest, a 10% annual return, no matter how scary the volatility of the market gets at times (think the 2000 dot com bubble, the 2007 mortgage crisis etc.) is really an amazing sight to behold, and in fact can almost guarantee your retirement nest egg if you do it properly. Looking at what a theoretical perspective of what a 10% annual return does year after year, we can look at the following spreadsheet:
Now, if it was 10% year after year consistently, then well, everyone would be in the stock market, and one of two things would happen, either life would be paradise for all because everyone would quickly see that it was guaranteed to do that, OR the more likely thing, the efficiency of the stock market would no longer allow this to happen. What actually happens in reality, and what we should be glad occurs, because it keeps our 10% annual return going (even if it’s very inconsistent and volatile in the short term, and it’s actually a 9.8% return for the S and P over the last century or so) is that, as stated in the former, year 1 will return 5%, year 2 will return 9%, year 3 20%, and then year 4 will lose 9 %, year 5 will lose 11% etc. To illustrate the volatility of the stock market on a more real world scale, here’s what your money would look like, from the actual real-world data, had you put your money in the stock market over the last 25 years, call it from January 1, 1993 through December 31, 2017 (I’ll stop there since 2018 is going to be a down year anyways, unless something pretty drastic happens….like an 8% increase in the Dow Jones Industrial Average this coming week as I’m writing this chapter…will update if necessary…but it won’t be necessary.) The data is as follows:
How The Dot Com Bubble Relates to Diversification
Not too shabby at all, had you put your money in back in 1993, right as the ball dropped on New Year’s Day, put it into a tax deferred retirement account, and left it in there until New Years in the year 2018, first of all you’d be touted as a financial genius by your friends, most of whom would’ve succumbed to their more animal instincts and done things like pulled out of the market, or gambled too heavily with high risk securities during eras like the dot com bubble, rather than just staying the course in an index fund, and you also would’ve made a heap of money on your principal. I’ll save you the burden of having to read 5 more pages of charts in order to really hone in on my next analogy here, but had you put that original $40,000 that we discussed you had inherited right out of college (my how that would’ve been nice) back in 1993 right after your graduation, and left it in there for 25 years, through January 1, 2018, it would be worth $576,151.08 (remember in the previous problem the time frame was more like 42 years, which is why the difference). Compared to just getting the 10% annual interest rate I talked about earlier, you would have just $433,388.24, holy heck does money really add up when you factor in the potential gains from diversifying and holding an index fund for the long haul!
Had you started investing in 1993 again, with your $40,000 principal in a tax advantaged account, and had also put in $5500 per year (the max amount you are allowed to contribute to a Roth IRA) that also grows tax free, the results are truly astounding, and your principal after 25 years would’ve been, assuming the continued 11.26% rate of return annually on average, $1,304,585.65, boy would that be a nice little retirement account to sit on and draw money from once you hit 70 ½ years old and you can pull money out without penalties. That’s a heck of a lot of cruises to Europe, flights to China and vacations to Progue let me tell ya!
Now, having looked into all of this, and knowing that it really is possible to get a very high rate of return through nothing more than simple passive investing, I’m sure at least a handful of you, and most likely a big handful of you if you’ve purchased this book after reading my blog, are thinking that you can beat that 10 or 11% annual rate of return with things like day trading, speculation and active management (market timing, putting money into fixed income over equities in periods of economic downturn and vice versa etc.). And while I’m hoping that at least one of you are eventually right….because that means that I’ve sold enough copies of my book to find an extreme outlier and that I’m now a multi-millionaire, the simple reality of the situation is that this is next to impossible, and that, especially after taxes, transaction fees, and last but not least, the amount of time spent trading, reading charts, reading fundamentals etc. that you could use to say..work another job…to put money into an index fund, that the odds are seriously against you. In later chapters from this book, I’ll go into more detail on why buying a passively managed index fund with the lowest fees possible is always the best way to go, will explain to you why the vast majority of fund managers know not a lick more than you do, and of why you probably don’t want to actively trade using either technical or fundamental analysis. In Chapter 12, I’ll also look into just how much fees add up in the world of investing when you’re looking at which index or mutual fund to buy, will look into the difference between mutual and index funds (one is actively managed and costs a lot more money, as what this boils down to is that the fund manager inevitably needs to get paid), and will discuss how active management is risky based on the overarching and extremely compelling academic research on the study.
Chapter 4 – What Determines the Prices of Stocks, How to Sort Through the Noise of Earnings, Ratios, And the Like
So, what exactly determines the prices of stocks, what the heck does that P/E ratio mean that you keep hearing about on CNBC, how do you determine whether or not a stock is overvalued, and how exactly can you determine when, where, or what to buy as a stock? While I will absolutely be sticking with my thesis of this book, which is that holding a passively managed index fund with the lowest fees possible, that you buy, hold, and dollar cost average into forever, is essentially the way to go (dollar cost averaging means that you put a consistent stream of cash into the market no matter what it is doing, however while it’s high, you put less in, and while it’s low, you put more in, the jig is still up on how well the market timing aspect of this actually works). With this in mind however, I can absolutely acknowledge that there are many other investment strategies out there, and that yes, they do occasionally work, and that you should likely have some exposure to them so that you can make this decision for yourself, I will do my best to highlight these within this chapter.
And now onto the topic of what determines stock prices, and what the gist of the ratios and major vocabulary words related to determining the price of a stock that you will frequently see in popular media mean, I’ll try to stick to a dozen or so major terms so as to keep this chapter general. For the purpose of this chapter, I will determine what exactly goes into a stocks price, and the importance of a company’s:
Holding Period Return
Rate of Return
Put Option (Options discussed more in depth in a later chapter.)
And why it’s good for you to know these factors, I’ll also be using a lot of these in future chapters in order to explain terminology, create examples etc. and rather than me going through and explaining it each time the term comes up in a chapter, I’ll leave it here as a sort of reference chapter that you can refer to that will walk you through it in detail (I’ll also include a glossary in the back of this book that you can turn to in times where you are unsure of a term etc.). With that being said, let’s dig right into the meat of these terms, what they mean, why they are important, and what these specifics are made up of, the ratios will become hugely important to know once we dig into the fundamental analysis portion of this book, so I’ll start with those first as that is the bread and butter of the subject of Finance, and of what really makes up a stock.
Starting Off, The Price to Earnings Ratio
You’ll see me mention this ratio a lot throughout this book, and you’ll also see the financial news bring up this particular ratio quite a bit as you continue on your journey through becoming a Financial magician, and for good reason, this is one of the most telling and important ratios about a company and about a stock, and tells you a great deal about whether or not a stock, or an index, is overvalued or not, something you definitely are going to want to know if you are going to be sinking your teeth, and a large portion of your retirement savings or available liquidity, into a company or into a stock market.
The P/E ratio stands for the “Price to Earnings Ratio” of a stock and is mathematically defined as the Price Per Share of a Stock, Divided by the Earnings Per Share of a Stock. The higher this multiple is, the more overvalued the shares are likely to be. Looking at the math formula in more detail, we get the following:
Diving into this further, we must look at each individual component of the Price to Earnings ratio. We know that the price per share is quite simply, the current stock price of a company. The Earnings per share of a company however, is a little bit more than that. The EPS of a stock is defined as the total earnings of a company, divided by the total number of outstanding shares of the company, or to simplify that even more, the total net income of the company, divided by the current number of shares outstanding. Here’s the formula blown up:
Stock Price Volatility
Both the net income and average number of shares outstanding typically refer to the quarterly net income and shares outstanding. For instance, if we look at Amazon’s 2018 Earnings Per Share for the first quarter of that year, we get an EPS of $3.27 through 3/31/2018. We find this number by taking the net income of Amazon, which was approximately $1,628,600,000.00 for Q1 of 2018, and dividing it by the ~498,000,000 outstanding shares of the stock, as a rough average, for the first quarter of 2018. This gives you the $3.27 number that we get for Amazon’s EPS for the first quarter.
So, with this in mind, let’s say it’s March 2018, and we’ve just gotten our first EPS estimate for the first quarter of 2018, we can use this number to find our Price to Earnings multiple, also known as the P/E ratio (or sometimes just the “earnings multiple” of the stock, if we’re using the slang term) and can take the price of Amazon on a date in March 2018, (lets go with March 15th, the ides of March) which was $1582.32 at closing bell, using this number as our numerator, and plugging in the EPS that we just found, of $3.27 as our denominator, we come across a P/E ratio of ~484, which is, needless to say, extremely high. Historically, the average P/E ratio over the years has been about 25, and since there is a fair amount of research showing reversion to the mean with regards to the stock market (ie. that overvalued stocks, and overvalued items for that matter, like in the case of the Tulip Bulb Craze, always fall back to what they are actually worth.)
In Amazon’s case, it is something of a huge outlier, as even if you had bought their stock at an almost 500 P/E ratio, you would have made money had you held it to this moment (even though the number of stock splits and shares outstanding have increased so much that it is now a MUCH more manageable P/E ratio of 81). Amazon is a fluke because, historically, had you done that with almost any other company, whether the new hottest tech company or otherwise, you would have lost a huge proportion of your capital. Refer back to the “dot com bubble” portion of the historic bubbles chapter, you’ll see that the P/E ratios of some of the top named companies of the time, were nothing close to what Amazon was in the 2018 example we just mentioned, instead they were merely over 100 (Amazon) or 175+, in the case of Cisco Systems, and investors who bought at that height still got their a$$e$ handed to them.
Looking at less “dark horse” companies that completely put the rules to shame, looking at Walmart, Target, JC Penny, Apple, Berkshire Hathaway, and Exxon Mobile, each one of these was, at one time or another (and still are now…with the exception of JC Penny…mainly because its P/E ratio got too high and it became hugely overvalued) their P/E ratios are currently as follows:
JCP: No Longer Given (stock price fell from $11 down to $1, a huge amount of which occurred from a fall in search traffic from Google due to their shady ranking tactics). They, like Sears, are looking into filing chapter 11 bankruptcy right now, nevertheless, a lot of this was due to them being overvalued in the first place.
Apple: If Warren Buffet, the richest investor of all time is loading up on shares when the stock price drops, that’s usually a pretty good sign that you’ve found a good investment. Apple has a cool P/E ratio of 14.22.
These are all stable, worthwhile investments, each of which typically pays a very strong dividend, and each of which can be considered “buy and hold stocks” with many considering a few of these, like Exxon and Walmart, to even be in the defensive stock category (a stock with a very low Beta, usually is very stable in times of recession.) So, to make a long story short with regards to the P/E ratio, anything in the 20ish to high 40ish or low 50ish range, is usually not too overvalued, and would make an okay buy based on its earnings multiple alone. Obviously, this varies from company to company and from cycle to cycle, but over the long term, value investing (buying low P/E ratio stocks) has had high rates of return over time, more so than buying growth stocks (buying high P/E ratio stocks in the hope that they would go higher.) So, in wrapping up the earnings multiple portion of this chapter, the lower Price to Earnings multiple the better, lower P/E ratios mean that the stock may be closer to its real-value, whereas higher P/E ratios, especially when you start approaching 100 and beyond, signal that a company is overvalued, and that for a long term buy or hold, that you should likely steer clear (based solely on this factor alone) in that a reversion to its mean of 25-50 may be afoot.
The Return on Assets
I was watching a CNN interview the other day with Warren Buffet where he talked about his holdings in Kraft Heinz (a publicly traded company that is the merger of both the Kraft and Heinz food brands together) and of how their net income generated by the assets that they carry on their books is nearly 100%, and that that number is unprecedented by any other company out there. Now obviously, being Warren Buffet, he didn’t buy this company and hold it for 25+ years because of the statistics of one financial ratio, he bought it due to this, their strong brand, their strong, increasing dividend, their record of revenue, free cash flow and net income numbers, and a host of other factors.
With this being said, what he means by their ROA being 100%, is that for each asset that the company has, it makes that much money every single year. In this case, Kraft Heinz has about $7,000,000,000.00, or $7 billion dollars on their books that they use to generate income, and those assets generate about $6,000,000,000.00, or $6 billion dollars in annual net income, from those assets. For about a .90 Return on Assets. The formula for return on assets is as follows:
Or what is usually just net income divided by total assets if this helps you remember it better. And while this number might sound fancy, all it really is, is the amount of revenue that a company generates from their assets. So to try and simplify this, if you run a small business that has $10,000 worth of assets (equipment, inventory, etc.) and you make $5,000 in net income, your ROA would be .5, because you make a 50% return each year on your assets. In the case of craft, a $6 billion return on $7 billion of assets, gives you (take 6 divided by 7) a return on assets of .86, or an 86% return each year on your assets. To put this into perspective, I can see why Warren Buffet likes this annual return, in that the average ROA of a company is closer to like 25-30%, so he’s found a gem indeed with holding Kraft Heinz. If this company is still sitting at $35 after its strong dip while you’re reading this, and you’ve been looking into re-allocating some of your portfolio to increase exposure anyways….this might not be a bad semi-speculative investment to get into as a buy and hold strategy for the time being.
To close out the ROA portion of this chapter, the ROA is important for an intelligent investor to know, because it shows how well a company uses their total assets to generate earnings, or net income. This is crucial to know for anyone buying shares of a business, in that a companies ability to generate large amounts of revenue relative to its assets shows that it is investing its money into the proper tools to generate money, as well as serves as a kind of risk management, in that company’s with a high ROA typically have enough cash flows and earnings to pay their employees, their debt holders, their dividend recipients, and the like, and stay in business over the long haul.
The Return on Equity
Somewhat similar in its formula to the return on assets of a stock, the ROE, or the return on equity of a company, is the amount of income that a company is able to generate for each dollar of equity that a company holds on their books. This equity is usually in the form of stock, or ownership in a company, however this can sometimes be artificially inflated by taking on excess leverage via debt or bonds. Regardless, the gist of the ROE ratio is how well a company is able to produce revenue using equity. The formula for this is as follows:
What this fancy formula means…. essentially, is that if you take the earnings of a company and divide it by the amount of equity that a company has outstanding, especially in the case of a publicly traded company, that you get a ratio of how effectively a company is able to generate income and a rate of return for their investors. For instance, the Q1 2018 return on equity of Apple stock was .4, or 39.97%. What this means, is that overall, annualized, that Apple returned almost 40% to its investors for the year, which is way above the average in the overall stock market, or even for the highly bullish tech industry. Keeping this short and sweet, since this is a very mundane ratio, the return on equity shows how well a company that dishes out equity to common holders as a form of fundraising, uses that equity to generate a profit, and as such, return overall capital gains and monetary returns to its investors.
The Dividend Yield, and Why It Often Hit .01% During The Dot Com Bubble
Moving on to the dividend yield on a stock, this stock is actually incredibly simple, you just take the dividend, divided by the price of the stock, to get the percentage yield that you got on your money. So, to keep this example easy, observe the following:
You put $1000 of your own money, into Amazon stock (sorry I like Amazon, and Bezos is all over the news for a cheating scandal currently so its been at the forefront of my mind I guess) at $1000 per share, Amazon pays a dividend of $30.00 per share, on its current price of $1000 (Amazon actually pays no dividend currently, this example is strictly for academic purposes). In this case, you would have a 3% dividend yield, just take the dividend amount, divided by the current price of the stock, or 30/1000, to get the 3% number. And voila! That’s what a dividend yield is. In Financial Mathematics terms, it gets a tad bit more complex than just dividing the current monetary dividend by the current price of the stock, and is instead denoted as the formula below:
Which is a small piece of what we call the “dividend discount model” in finance, this formula in particular means the next dividend payment divided by the current price of the stock …. but anyways, that’s the gist of the dividend yield, the return you get on your money from a dividend.
Rate of Return
The rate of return on a stock, or on any investment for that matter, is actually pretty simple and is just like it sounds, the return that your investment gives you. So, for instance, if you have Apple stock at $1000 per share, and it goes up to $1200 per share, then you would’ve had a 20% rate of return for whatever that time period was that you held the company. The rate of return of a stock can get a little more complex than the aforementioned example when you consider the holding period return on the stock, which is the total rate of return when you include dividends, capital gains, share buybacks, share disbursements, and the like. An example of this would be if you bought Apple stock at $1000 per share, while it was paying a 1% dividend, and then the share price rose to $1200 and you sold it, your total holding period return would be 21%, in that the amount of money in your pocket in total at the end of the day, was $1210 on a $1000 investment. The formula for this is denoted as follows:
Which is that the rate of return on an investment is equal to the next years dividend, divided by the current price of the stock, plus the growth of the stock. An example of this would be if you had a $10 dividend, on a stock worth $500 currently, that grows 10% during the year. R, or your rate of return, in this case, would be equal to 10/500 + .10>>>>>which equals out to a 12% rate of return for that particular stock over the course of the period, typically a year. And that’s it, rate of return is just how much an investment yields over a certain period of time, so when that CD earns you 3.5% annually for 5 years, your ROR for the first year would be 3.5% etc. (depending on compounding periods, bank APY marketing discrepancies etc. …. but that’s the gist of it.)
Market Cap, Also Known as the Market Capitalization of a Stock
The market cap of a stock is another extremely common, very important financial definition that basically stands for what a company is “worth” as a whole. If you go to your trusty Google search engine, and search for any stock (go ahead, type in “Google stock quote”) the first thing that will pop up is a screen that will show all kinds of data about a stock. If you did it right now, you’d see either a green or red arrow (pointing up or down for what happened with the stock on that day, or on the previous trading day that the market was open), and you’ll see the share price, which right now is around $1100 per share. You’ll also see a number of financial ratios, including the Price to Earnings ratio, or the P/E ratio that we discussed early, and would likely get a value at like 50 or 70 if I remember correctly. Then you’d see other numbers like the EPS, ROA, a chart showing the recent trend of the stock in the market, and finally, in the lower right-hand corner, the last item should say “mkt cap.” That my friends, is what the stock is worth as a whole, and in Google’s case, depending on what day you are looking at it, it looks to be worth somewhere around $800,000,000,000.00 and $1,000,000,000,000.00, or between $800 billion and $1 trillion dollars, not too shabby. To get the market cap of a stock, which is the stocks total value, it is actually very simple, just take the current share price of the stock, which in Google’s case pretend is $1100 a share, and multiply that by the number of shares outstanding, which again, in the case of Google, is approximately 727.3 million shares, you multiply those numbers together and you get a market cap of $800 billion (these numbers aren’t exact just a ballpark.)
How the Federal Reserve Moves Equity Markets Through Interest Rates
This section might get a tad bit more complex than the previous paragraphs, so hold on tight and get ready to possibly read this paragraph a few times. In this section, we’ll look into the federal reserve, how and when they typically change interest rates, and of what interest rates typically do to the equities market (the equities market is financial slang for the stock market.)
The Federal Reserve is actually a private organization that works on its own behalf outside of the United States Government. Yes, you read that right, the federal reserve lives in the private sector, and aside from obeying government laws, have their own oversight over what happens with interest rates, and a host of other types of fiscal and financial policy. The federal reserve as most people know them, is responsible for movements in interest rates, so that’s where we’ll dive into today with regards to what the reserve does.
One major point of the federal reserve is that they increase or decrease interest rates every quarter, in their quarterly board meetings that they have, according to how they feel the market is, ie. whether it’s too high or too low, will determine whether they increase interest rates, decrease interest rates, or leave them the same. If the market appears to be over-valued to the fed, than they will typically increase interest rates, in hopes that it will drive the market down, reducing inflation (I’ll explain more in a second why this is actually a good thing over the long term.) If the market is too low, and it looks like we are in the midst of a recession and need to pull out of it (as a recession is terrible for unemployment) then they will lower interest rates, which will increase the stock market. Now, how and why do interest rates influence what the stock market does? The answer is actually quite logical, however there’s really 3 main reasons why interest rates influence the stock market, and so on that note, I’ll give you the simple answer first, and the complicated answer second.
The 3 main ways that interest rates influence the stock market, they are as follows:
- It makes it more expensive for corporations to take on leverage, in that they have to pay an interest rate on debt they take out in order to bolster cash flow. Think of it this way, every dollar a corporation can use to increase their own revenue is beneficial to the shareholder, in that it increases the stock price, and everyone makes money. If Apple has $10 billion worth of debt that it’s using to produce more iphones in China, and it goes from paying 7% interest annually on that debt, to 8% interest annually because the federal reserve raises interest rates, then the company just lost $100,000,000.00 annually, that gets passed to the shareholder, and the stock market falls, ie. corrects.
- The most common-sense answer to why increased interest rates makes equities less attractive, and therefore make them fall, is that the consumer no longer sees the opportunity cost as worth it. If you can get 4% annually, or 5% guaranteed in a savings bond yearly, with 0 volatility and with practically 100% certainty of that exact ROI on your money, than you will be less likely to put your money in an S and P 500 index fund, even if it yields you a 10% average annual return over a 20 year period, due to its harsh swings and volatility in comparison to the bond. Why lose the extra few hours of sleep if you can make more money in the short term and have a lower heart rate in the long run!
- The most difficult answer is something that might be tough to understand if you don’t have a finance degree, or if you aren’t a confidant on the subject, but I’ll discuss it anyways in case anyone here wants to really dive into some of the details of financial mathematics. One of the major reasons that higher interest rates lower stock prices, is that it increases the discount rate at which you discount future cash flows (stay with me here.) So, one of the most common ways of valuing investments, both in the near term and especially long term, is a value investing method in which you predict future cash flows, say 20 years down the road, these would include your net income, operating profit, EBITDA, and the like. You use the average growth rate of these cash flows over the last 20 years or so, blended with a more recent rate of growth, in order to find a useable growth rate to project these cash flows. From there, you discount this number using the risk-free rate (the rate of interest on a 10-year United States Treasury Bill) in order to discount these future cash flows. You then discount this by about 30-50%, and if you can find a stock that’s priced at that level, then BUY BUY BUY because you’ve got a bargain. This is the gist of the Warren Buffet and Benjamin Graham Intelligent investor method and is still widely used today on the street. So with all this in mind, that’s another major reason why it affects stock prices – for more information on this be sure to check out inflationhedging.com, we have tons of blog posts on the Graham investing method to help you further understand this concept.
The beta of a stock typically ranges from 1 to 4, however I’ve seen plenty of stocks that are higher than 4, and plenty of defensive stocks (basically recession proof stocks) like Walmart, with a low beta of like .75, which are lower than that of the overall stock market, of which has a Beta of 1. Beta is a measure of risk and volatility in the stock, and while it can be useful, it is somewhat flawed in its metrics in that it correlates volatility with risk…. which isn’t always necessarily the case. To illustrate why not, I’ll use Warren Buffet’s analogy from the 1995 Berkshire Hathaway Annual Shareholders meeting: “I once had a chance to buy the Wall Street Journal after it had fallen in value from $750 million, down to $200 million dollars in its market cap, while none of the fundamentals of the company had changed at all. The analysts however that were looking at the company had made the Beta go up from 1 to 3, which they said made it riskier, since it had been so volatile as of late. The thing I can’t figure out, is how they came up with that, because if you can buy the exact same company for a third of the price that you could yesterday with no changes at all to the company, I call that significantly less risky, not riskier.” And he is absolutely right in his thinking there, if you don’t grasp that concept at first, read the quote a few more times until it sticks, and then you’ll get it, I had to read it twice myself before I fully got what he was saying. So, in keeping this short, Beta is a measure of volatility, the higher the Beta, the more volatile, and as such riskier, the stock is.
A short position is essentially betting against a stock. If someone says to you that they are shorting Apple, it means that they are buying the stock at $250 per share and hoping that it falls down to $200 per share so that they can cash in on their short position. The way a short position works is typically on a margin, and will have the short seller borrowing shares from their broker at one price, and returning the shares at another…basically lower…..price. Nowadays, this all happens 100% automatically, and you need just log into your trusty E-Trade account and click on “short” next to the stock that you’d like to buy. The concept of a short sale, however, is really that of a loan, in that you are borrowing shares, followed by returning shares. If the shares are worth less when you return them, than what you paid for them, then you keep the difference, if the opposite is true, then well, you lose money, and can often times lose a pretty substantial amount at that. Regardless of the technicalities behind this, the gist of a short position is when you bet against a stock and hope that it goes down.
You bought a stock, and you hope that it goes up, that’s a long position. It is the contradictory position to a “short” sale, in which you hope that the stock goes down. 99% of people that buy stocks are holding long positions, if you are an aspiring retiree with $100k in a mutual fund, than you my friend, have a long position on stocks.
I will touch on the subject of options only briefly here before we close out this chapter, in so much as I will be discussing this in much more detail in the closing chapters of this book. For right now, I just need you familiar enough with this concept so that I can use the term casually in some of my upcoming chapters. The main thing to know about options, is that they are a form of leverage. Remember when we talked about short and long positions a second ago, well options, namely call and put options as they are called, are just leverage forms of these positions. A call option, is a leveraged long position, you hope that the stock goes up, while a put option, is a leveraged short position, where you hope that the stock goes down so that you can cash in on it. Call and Put options typically work something like this, you spend $500 on call options while Amazon is trading at $1000, your option has a “strike price” as they call it, of $1200, which means that you can only exercise your option (use your option…..similar to what is essentially just selling your shares of stock) once the stock hits $1200. Now normally, without leverage, you would make 20% had the stock moved that much. With an option, you can make as much as five, or ten times your money on a move like that, depending on the type of option (European Options vs American Options…differences explained further in a later chapter), however it needs to happen in what is usually a relatively narrow period of time. The downside to options also, is that you lose 100% of your principal if you are wrong, like in the case that you buy an option on Amazon while it is trading at $1000 per share with a strike price of $1200, and it only goes up to $1100 and then stops, you are out ALL of your principal, and lose 100% of your money. A put option, is simply the reverse of this. As Warren Buffet says about options “they are weapons of mass destruction” even though he has used some at certain points in Berkshire Hathaway in order to hedge against risk, again, more on that will be explained in a later chapter.
In Conclusion, My Final Thoughts on The Dot Com Bubble, and Other Bubble Mania Crisis Throughout History
And that should be a pretty good opening glossary for now, at the recommendation of a good friend of mine who read the first few sample chapters of this book (thanks Alex, much appreciated), I will be including a very detailed glossary in the back of this book that you can refer to with any definitions that you may get stuck on, that should make your reading go a lot more smoothly than if you had to take out your phone to Google search a term every time a foreign one came up. For now however, I think that this snippet of definitions should do us some good in your journey towards becoming a true Financial magician, and that now that you have some mild exposure to these concepts, you should be able to grasp the concepts later on in this book all the more easily. Until then, onward to technical analysis! And for more information, subscribe to our blog for a free copy of my upcoming book, and be sure to comment with any thoughts you may have on the blog post.
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