How to profit from the stock market

In previous posts of the Personal Finance Basics series we covered:

• How the stock market works
• What the S&P 500 and the Dow are
• The pitfalls of investing in the stock market
• The stock market is a wealth-generating machine

As a summary, we learned that:

• The value of the U.S. stock market has increased over the past 100+ years
  • This increase hasn’t been constant. There have been numerous economic downturns and stock market crashes.
  • And yet, $1,000 invested in the S&P 500 in 1980 would grow to $34,700 by 2022.
• All of the companies in the stock market today will one day disappear
  • Companies in the S&P 500 had a lifespan of 30 to 35 years in the 1970’s. This tenure has since decreased to 15 to 20 years. The rate of change is accelerating.
  • None of the world’s largest companies in 1989 retained their spot in 2021.
  • New technology, relentless competition, and poor leadership means companies will continue to go out of business.
  • This makes it incredibly difficult to predict which companies will be studs and which will be duds.
• Five of the reasons for the stock market’s increase are:
  1. Inflation: the price of goods has gone up over time.
  2. Population growth: more people means more workers and more consumers.
  3. Technology: new technology creates new industries (e.g., cars require gas, tires, mechanics, etc.) and makes people more productive (e.g., it’s faster to sew a shirt with a machine than by hand.)
  4. Natural selection (survival of the fittest): only the profitable companies survive over the long run.
  5. Animal spirits: humans are irrational and so the stock market is as well. When the economy is sucky, a dark cloud dampens our spirits. But when we—as a collective—feel hopeless (e.g., due to war, global warming, etc.), the economy also suffers. It’s a bidirectional relationship.
• Economic growth is not a law of nature.
  • Given water, sunshine, and suitable soil, a tree will grow. This is a law of nature.
  • The same cannot be said of the stock market—our economy is a human creation. Growth is not guaranteed.
  • Case in point, the Nikkei 225, the Japanese version of the S&P 500, peaked in 1989 and has not again reached its former height.

At this point, two facts about the stock market should be clear:

1. It’s full of danger 🚨
2. It has wealth-generating potential 💰

In this post we’ll talk about how we can tap into the stock market’s wealth-generating potential while mitigating its dangers.

How much is a company worth?

If we’re comparing two companies, how do we know which is more valuable?

Do we take a look at sales or profit?

Do we consider the debts and assets of the companies?

Sidenote

Is a company that owns billions of dollars worth of real estate more valuable than one that owns no real estate but has higher profits?

McDonald’s, for example, has 38,695 restaurants in over 119 countries. They own the land on which their restaurants are located—over $30 billion in real estate. Their revenue, however, isn’t growing very fast.

Chipotle, meanwhile, has 2,966 restaurants in 5 countries. They lease their buildings so they don’t have real estate assets. Their revenue, however, is booming.

Similarly, is a company that’s losing millions of dollars but growing at hyper-speed more valuable than one that’s highly profitable but growing slowly?

An example here would be DoorDash—high-growth but losing money—versus Procter & Gamble—a mature company with slow, steady growth.

As you can see, there are lots of different ways we can compare two companies. And the results will vary depending on the criteria used.

Market capitalization

For public companies that sell shares in a stock exchange, market capitalization (commonly called market cap) is the measure typically used to rank companies.

Market cap represents the market value for a company. In other words, it’s the amount of money it would take to purchase the entire company.

To calculate a company’s market cap, we multiply the company’s share price by the number of shares of the company that are held by investors.

Let’s say we want to calculate Tesla’s market cap. To do this, we need to get Tesla’s share price and number of shares outstanding.¹

We go to the Barron’s page for Tesla and see that its share price is $288² and the number of shares outstanding is 3.13 billion. Multiplying these numbers, we arrive at a market cap of $901 billion.³

Buying the whole market

A couple of posts ago, I proposed a solution for sidestepping the difficulty of deciding:

1. Which company’s stock to buy
2. When to buy and sell

This solution was to buy stock in every single company and to hold these over the long term.

But how the heck are we supposed to buy stock in every single company? There are thousands of them.

And in what proportion am I supposed to buy them? One of each?

The answer to the first question is an index fund; the answer to the second is market cap.

Index funds

Say Rafael and Sofia want to start investing. Rafael is a caffeine-fiend so he buys a share of Starbucks. Sofia is a gamer so she buys a share of Nintendo.

Rafael and Sofia are now tied to the fate of a single company.

What if Elon Musk started a new coffee company called UniverseBuckaroos and drove Starbucks out of business?

What if Mario, Luigi, Peach, and Bowser went on a labor strike and refused to participate in any new video games? Nintendo stock would surely crash.

Hedging the bet

Rafael and Sofia think this over and realize that tying their finances to one company is too risky.

To diversify their investments, they decide to share ownership of their Starbucks and Nintendo stock. That way, if either Starbucks or Nintendo tanked, they’d still be OK.

Rafael and Sofia high-five and do a little happy dance. Then a simultaneous thought occurs: why stop here?

What if they roped in 998 of their closest friends and created a giant shared stock pool?

Each person would buy a share in a different company and add it to the pool. They’d then each own a thousandth of a share in 1,000 different companies.

By doing this, Rafael and Sofia would no longer be solely betting on Starbucks and Nintendo, but on the growth of industry and technology in the United States as a whole.

If a few of the thousand companies crashed and burned, they’d still be alright as the gains in the other companies would pick up the slack.

Hold on a second

Rafael and Sofia start going through their rolodex, calling their friends with their terrific idea, when Sofia is stopped in her tracks by a thundering realization: buying one share in each company makes no sense.

How does it make sense to buy the same number of shares in Apple and Starbucks when Apple’s market cap is 26⁴ times larger? Shouldn’t there be 26 shares of Apple for every 1 share of Starbucks?

And, hey, hold on a second—how is it fair that Pedro buys a Macy’s share that costs $17.81 and Carla buys a UPS share that costs $167 and yet they both get equal ownership of all shares?

This approach, Sofia reasons, is all wrong. They shouldn’t buy a share in each company.

Instead, they should pool their money and distribute it among the companies based on each company’s market cap.

Ranking the S&P 500 by market cap

A quick search reveals that the total market cap of the S&P 500 is $35.1 trillion. This means that if we add up the market cap of each company in the S&P 500 we’ll get $35.1 trillion.

This will be our denominator—we’ll divide the market cap of each company in the S&P 500 by $35.1 trillion to figure out what percentage of the S&P 500’s total market cap the company accounts for.

Sofia finds a list of the companies in the S&P 500 ranked by market cap and sees that Apple is the king with a market cap of $2.5 trillion.

2.5 trillion divided by 35.1 trillion is 7.12%. This means that 7.12% of the money should be used to buy Apple stock.⁵

Sofia creates a spreadsheet to calculate this percentage for the other 499 companies in the S&P 500.

Here’s what the first eleven rows of the spreadsheet look like:

Now all Sofia and Rafael have to do is collect the money from their friends and distribute the funds according to the spreadsheet.

If they managed to pool $1,000:

• $71.20⁶ would go towards buying Apple stock
• $55.50 towards Microsoft stock
• $37.60 towards Google stock
• $36.80 towards Amazon stock

and so on.

This already exists?

Rafael and Sofia pick up the phone again and begin calling their friends to explain the new plan.

Luckily for them, the first person they call is Andrea who tells them that their revolutionary idea already exists—it’s called an index fund. Vanguard, Fidelity, and lots of other online stockbrokers offer them.

Andrea explains that companies like Vanguard and Fidelity pool money from investors and use this money to buy shares of companies. This is called a mutual fund.

An index fund is a type of mutual fund that tracks an index to decide how to invest the pool of money.

An S&P 500 index fund, for example, would distribute the investors’ money in the same way that Sofia had planned—that is, by allocating a portion of the total funds to each company based on the company’s weight in the index.

These index funds spare us the arduous task of buying every company in the stock market and so the companies that manage these funds charge a fee for the service.

As long as this fee is low—under 0.05%⁷ ideally—then this is a worthy tradeoff to avoid this complexity.

Sofia and Rafael breathe a sigh of relief, throw their rolodex out the window, and go for a long walk in the park.

Summary

Consistently buy an S&P 500 low-cost index fund. Keep buying it through thick and thin, and especially through thin.

In this post we learned that:

• There are many different ways to compare companies.
  • We can compare companies based on their revenue or their net income or on the value of their assets or on how fast they’re growing.
  • Two people can look at the same company and come up with completely different valuations depending on the numbers they choose to focus on.
• Market capitalization (market cap) is the measure by which public companies are ranked.
  • A company’s market cap is the price we’d have to pay to purchase the company outright.
  • To calculate market cap we multiply the number of existing shares (shares outstanding) by the share price.
• By buying shares of every company in the stock market, we diversify our bet and avoid tying our finances to the fate of a single company.
  • This is a bet on the future of the industrial and technological capacity of the United States—and the world—as a whole rather than a bet on the future of a single company.
  • Ask yourself, am I more likely to bag a winner if I buy stock in 500 companies or 1 company?
• Investors can pool their money together and use this money to buy shares of companies in the stock market. This is called a mutual fund.
• An index fund is a type of mutual fund that uses an index, such as the S&P 500, to decide how to apportion the investors’ money.
  • An S&P 500 index fund divides the pool of money among the 500 companies based on the ratio of each company’s market cap to the market cap of the S&P 500 as a whole.
  • Apple accounts for 7.12% of the total market cap of the S&P 500 so 7.12% of the pooled money would go towards buying Apple stock.
  • Companies that manage index funds charge a fee for the service. A fee under 0.05% is very good and is a worthy tradeoff for taking this complexity off our hands.

In the upcoming posts we’ll take a closer look at index funds and then take a second to review everything we’ve learned so far about the stock market and investing.

I hope this was helpful. Feel free to send me an email if you have any questions.

And if you’re looking to learn more, you can check out the whole Personal Finance Basics Series.

Video for this post

If you prefer watching to reading, here’s an easy-to-follow video I made with all this info:

Slides for this post

If you’re interested, check out the slides I made for the video.