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Stock Market Basics

Bulls and Bears

Whenever the stock markets set new highs, a whole universe of business pundits and supposed experts pontificate on the meaning and consequences of the records. Some are bears that predict a coming collapse; others, the bulls, point out reasons the market will go even higher.

Stock Market BasicsWhoever is right, the fact is that for over 200 years the market is a story of ups and downs. That means whatever the near-term projections, the market will ultimately decline and ultimately raise again. These market cycles impact business, investors, and other investments. Because the cycles create joy and fear, they are emotional events to many. History shows that the investment world is as much about these emotions and attitudes as realities and economics.

The Underlying Principles

There are several basic principles that drive the investment world. Foremost is the concept of risk versus return. Simply stated, there’s no such thing as a free lunch. Investors get a return on their investment commensurate with the risk to the capital put in play. There are several different forms of risk including liquidity risk, credit risk and market risk.  Liquidity refers to how easily an asset can be bought and sold or converted to cash. Credit risk, also called default risk, is the risk associated with a borrower not making payments as promised. Market risk is the risk that the value of a stock will decrease due to the change in market factors.

So liquidity risk is a short term risk, in that the value is there but you just can’t get it right away. Credit risk applies to individual companies being unable to pay their bills and market risk can apply to the overall market or individual shares.  For instance, in 2008, many investors lost 50% or more of the value of their stock portfolios. The overall market became illiquid and with no buyers the overall market fell. Many of those values are now restored. However, the weaker ones (with higher credit risk) were weeded out i.e. declared bankruptcy.

The Diversified Portfolio

The last few years highlights the stregths and weaknesses of a diversified portfolio, holding assets that counterbalance the broader swings of the market. Unfortunately, in extreme cases like 2008 when everyone lacks liquidity all prices fall because there are no buyers. It is times like these where value investors like Warren Buffet sweep in and snap up the bargains that no one else has the cash to buy. Some may consider him to be an opportunistic vulture taking advantage of cash strapped companies but when a company is desperate for cash they see him as a saving angel preventing them from having to declare bankruptcy. So the first lesson of diversification is to protect against liquidity risk by having a large enough portion of your assets in cash and other highly liquid assets.

Beta

A key issue in diversification is the correlation between assets, called “Beta”. A Beta of “1” means that the two components move 100% together.  Purchasing two stocks with a Beta of  “1” would produce no diversification.

A Beta of “-1”  means that the two components move in exact opposite directions. Theoretically, putting half of your portfolio in each of two stocks with a beta of “-1” would eliminate volatility but would result in no gains either. Although in practice no two stocks ever have 100% correlation or 100% negative correlation. The benefits of diversification increase with lower correlation. But diversification has costs as well. A diversified portfolio will by definition never be the best performing portfolio since it will have some components that perform well while others perform poorly. In other words, by avoiding the worst performing portfolio you give up having the best performing portfolio.

Diversification can be across different asset classes such as Stocks vs. Bonds vs. Gold or within asset classes such as industrial stocks vs. financial stocks vs. transportation stocks. It can also be across regions such as U.S. stocks vs. International stocks. Obviously, better diversification is obtained by combining all of these types of diversification.

The Wealth Effect

Consumer spending increases during a market rise, since investors feel richer because their assets are increasing so they buy things. Generally, this is good for the overall economy and spurs further investing.  Generally, if the stock market is setting highs, it means interest rates are at a low. This is also good for real estate. Most real estate involves debt, and low interest rates mean cheaper money is available to finance purchases. So the stock market and the real estate market have a positive correlation due to interest rates but due to other factors the correlation or Beta is much less than ‘1″.

According to Realmarkits a good estimation of the correlation between stocks, bonds and real estate can be seen in the table below. These are not fixed relationships and they vary due to time but they will give you an idea of how the relationship works. Obviously stocks are 100% correlated with stocks, and bonds with bonds, etc. But stocks only move with bonds about 50% of the time. In other words, half the time stocks will be going up while bonds are going down and vice versa. By the same token, half the time they will be moving together as well. Real estate on the other hand only moves with the stock market 25% of the time and 75% of the time they move in opposite directions.

Correlation Stocks Bonds Real Estate
Stocks 100% 50% 25%
Bonds 50% 100% 0%
Real Estate 25% 0% 100%

The final factor we are going to look at is inflation. In times of high inflation (above 5%) people are concerned with preserving the value of their investments. This means that the stock must appreciate more than the inflation rate just for the owner to break even. Thus many investors turn to real assets like gold and real estate. But things with fixed values like savings accounts, CDs, and bonds do poorly. Recently in his publication True Wealth, Steve Sjuggerud of Stansberry Research published an excellent table showing the correlation between inflation and the stock market.

Inflation since 1950 Stocks return % of the time
Above 5% 0.5% 32%
Between 2.2% and 5% 8.5% 35%
Below 2.2% 13.2% 33%

On average stocks have yielded 7.4% a year since 1950 after inflation. As you can see from the table, inflation has been high roughly 1/3rd of the time, medium 1/3rd and low 1/3rd. Stocks make big gains when inflation is low but don’t make any money (0.5%) when inflation is high. This makes sense because you have to subtract the inflation from the increase. So even if stocks go up 5.5% and inflation is 5% your net return is only 0.5%. But the amazing thing is that when inflation is low  (below 2.2%) stocks have yielded 13.2% (so they actually went up over 15%! (15% – 2% inflation = 13% yield) and when inflation is moderate they have yielded 8.5%.

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Joshua Turner is a writer who creates informative articles in relation to business. This article describes investments in relation to the stock market and aims to encourage further study with a masters in public administration.

Image courtesy of Stuart Miles / FreeDigitalPhotos.net

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