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Every Investor Should Know the Basics of How the Stock Market Works

The controversy over the shorting of GameStop inspired a number of people who don’t usually post about stock investing on Twitter to do so. There was a woman who put up a tweet that made me feel both depressed (because the point she made was valid) and exhilarated (because her point reveals how much good we could do by taking some simple and obvious steps). She said: “Genuinely unclear as to why I had to take chemistry and calculus in high school to never use them again…. Meanwhile, I have no idea how the stock market works.”

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Most Lack The Knowledge Of How The Stock Market Works

This is most investors. I know because I have had conversations with tens of thousands of investors on the internet and MOST (not just a few) possess a poor idea of how the stock market works. I don’t pretend to any great expertise myself. But I believe that I have picked up a few clues here and there. Usually because I wanted to write about something and had to learn at least a few basics to pull it off.

Most people won’t admit how much they don’t know. That of course just makes things worse. If you don’t understand the basics and you know that you don’t understand the basics, you are open to taking advantage of opportunities to learn when they present themselves. Once you become defensive about your lack of knowledge, you build a wall that keeps out information bits that would scare you if you were to come to terms with them.

Trillions of dollars of market value were lost in the space of a few days during the 2008 economic crisis. There was one fellow on a discussion board who asked: “Where did all the money go?” I loved that because it is such an obvious and important question. It is my belief that fewer than one in ten of all investors know the answer to that question and that no one should invest one dollar in the stock market until she does.

Where did the money go? It went “poof!” It disappeared into thin air.

Ignoring The Reality Of Stock Investing

The reason why so few of us know the answer to that one is that we don’t want to know. It scares us to think that the money that we are planning to use to finance our retirement can just disappear one day. So we stop our brains from thinking about it. But it is the most important reality of stock investing.

Shiller calls the disappearing money “irrational exuberance.” It disappears quickly because it never really existed in the first place. Investors have the power to create money out of thin air by bidding stock prices up and of course we have every reason in the world to want to do that. But then we are shocked and depressed when it disappears. I think we should be more conscious about these things. If we are going to create pretend money, we should acknowledge that that is what we are doing when we do it. But it never happens like that. We always rationalize. We always pretend that the money we are creating out of thin air is real.

The Buy-and-Holders have a different idea as to where the money goes when prices crash. They say that investors are rational and always set prices properly. So what is happening when prices crash is that investors are suddenly becoming aware of some economic negative of which they were not aware in earlier days. If it helps you to sleep at night to think that, please feel free. But I am not able to believe the just-so story. My conversations with many, many Buy-and-Holders tell me that they do not really believe it either, at least not on a deep level.

Irrational Exuberance Theory

I always cite Shiller as support for my irrational exuberance theory since that is the title of his book. I have talked these matters over with thousands of Buy-and-Holders. I cannot recall a single time when the Buy-and-Holder said that Shiller doesn’t know what he is talking about. I also cannot recall a single time when a Buy-and-Holder identified some way in which Shiller’s research caused him to change some idea he once had about how stock investing works. If you go by what the Buy-and-Holders say, Shiller never made a mistake but he also never added anything to our storehouse of knowledge.

The Buy-and-Holders do not want to engage with Shiller’s ideas. That’s what is going on. They want to continue to believe that market prices change in rational ways because that is a comforting thought. So long as most of us believe that, we cannot take the steps we would need to take to make market rationality more of a reality. Irrational exuberance reigns because so few of us do anything to combat it.

The behavior of the stock market affects all of us. Having a market composed of people who don’t know how it works is like driving on a highway filled with cars being driven by people who don’t know how to drive. We need to know how this stuff works. And, as of today, we do not.
Please don’t think that I think that I know it all. I don’t think that. Where I think that I have an edge is that I have been placed in circumstances that caused me to become aware of how little I know about this important subject and I have engaged in at least some feeble effort to become at least slightly better informed.

Rob’s bio is here.

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