The stock market has always amazed me. It's such an integral part of our economy, our jobs and our financial futures yet the average person has very little knowledge as to how it functions. You would think that such an important aspect of our daily lives would have been taught to us in school, yet we walk away with only basic economic concepts.
The underlying fact is that because so many people know little about it, investing can be a daunting and in the case of Madoff, be a harmful experience. So much relies upon what we have already accumulated, yet we still aren't where we want to be. Understanding the stock market and how it functions can help us make investment decisions with a little more confidence.
The stock market can be compared to the World Series. There are two teams, announcers, an audience and a whole bunch of other components that really tie the two together concepts together in similarities.
In the stock market there are buyers and sellers, these can be likened to the two teams playing. There are two teams playing against each other and only one will win. The fundamental truth here is that in order to buy a stock, someone has to sell it to you. That means that the person selling it to you thinks no more economic value will be extracted from it while you think there is still potential. One of you is wrong.
Another component in the stock market is mutual funds. Mutual funds are the employees who work in the back office for the championship team. They'll get a ring if their team wins, but their bonus is never as big as the players themselves.
The audience can be likened to index funds, they're just there to watch be at the game and win over time just for being there. However, they don't really see any immediate benefit besides exposure to the game.
The announcers are like Wall Street, calling the play by play and reporting on recent happenings. They sway between excitement to lethargy depending on what is happening in the moment. However, as knowledgeable as they may seem, they cannot be relied upon to accurately predict the long term outcome. The only thing they do is broadcast and sometimes point out arbitrary facts.
Now that all the basic components of the stock market have been described, we need to talk about the game itself. Now while a typical World Series game lasts nine innings, the stock market world series is game that doesn't end. So how is a winner determined? The winner is determined depending upon the individual time horizon of the players on each team.
So if you are buying Procter & Gamble for a long term investment and it drops in the short term, you haven't lost the game yet until your time horizon has been reached. This allows there to be multiple winners and losers all simultaneously, making the game a little more fair to the participants involved.
Also, unlike the World Series where only one game is played at a time, there are many games being played all at once in the stock market depending upon what stock you are talking about. Each stock has its own game being played. So there is the Johnson & Johnson game being played along side the Procter & Gamble game and so on and so forth. As an investor, you will find yourself playing in different games on all different teams depending upon the position you've taken in your portfolio. Some you may feel are going to be winners making you a buyer, while some you may feel is going nowhere or down, making you a seller (or even a short).
This sort of competitive play goes on in all the different markets associated with the stock markets (derivatives, CDS's, futures, etc.) and it is up to you as an investor to decide what games you want to be in and what your role is going to be. Are you a player, a back office manager, or an audience member? It depends upon your strengths and comfort level in the games you are a part of.
(This article originally posted on April 19th, 2010 on Technorati. Read the original article here.)