Book summary “Why Does The Stock Market Go Up?”: summary

Introduction

You likely look at the stock market with a mixture of confusion and fear. Daily headlines report wild price swings, and you wonder if investing is just an educated form of gambling.

Brian Feroldi argues in Why Does The Stock Market Go Up? that the market is history's greatest wealth creation machine. You will discover that stocks are not mere lottery tickets, but fractional shares of real businesses that generate profits.

The book breaks down the mechanics of wealth creation into six clear parts. You will learn how companies generate value, why market crashes happen, and how compounding transforms small savings into a fortune.

The following questions guide the exploration:

• What actually happens when you buy a share of stock?
• Why do stock prices rise over the long term despite constant crashes?
• How do you build a resilient portfolio without paying high fees?

1. Stock Market Basics and Corporate Ownership

Stocks represent fractional ownership in corporations that generate value through profits, while major market indexes track overall economic performance.

What Is A Stock

A stock represents fractional ownership in a corporation, giving shareholders legal claims on company assets and profits. Corporations issue stock to raise money and provide legal protection for investors against personal liability. You can determine your exact ownership percentage by dividing your owned shares by the total shares outstanding.

Natalie, Ethan, and Lauren open a coffee shop called Best Coffee Company, contributing different amounts and owning shares proportional to their financial input.

Why Stocks Have Value

Stocks have value because shareholders hold a legal claim to a portion of the company's profits and assets. When a business generates net income, that money belongs to the shareholders. Management may distribute these earnings as cash payments or retain them inside the business to purchase equipment and hire employees.

Best Coffee Company makes $5,000 in profit in its first year and distributes it as a cash payment to Natalie, Ethan, and Lauren based on their share counts.

Market Indexes

A stock market is a platform where investors buy and sell shares, and stock market indexes track the overall performance of these baskets of stocks. The New York Stock Exchange and NASDAQ are major trading venues. Indexes like the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite help investors measure market movements using different weighting methods.

Charles Dow and Edward Jones added up share prices of 12 major companies in 1896 and divided by 12 to create the Dow Jones Industrial Average.

2. Going Public and Investor Returns

Companies issue Initial Public Offerings to raise capital, and investors earn money through capital appreciation and dividend distributions.

Why Companies Go Public

Companies go public primarily to raise capital by selling new shares of stock to public investors. Taking a company public via an Initial Public Offering allows businesses to fund expansion without incurring debt that requires mandatory interest repayments. However, this process creates dilution for existing shareholders.

Starbucks went public in 1992 through an IPO, creating 1,470,000 new shares at $17 each to raise $25 million to build new stores. At the time of its IPO, Starbucks had 140 locations. Existing shareholders experienced 12% dilution during the offering.

Investor Returns

Investors buy stock to make money through capital appreciation and dividend distributions. Capital gains occur when a stock is sold for a higher price than its purchase price, whereas dividends represent cash payments distributed from company profits to shareholders.

Alison buys Best Coffee Company stock at the IPO for $10 and later sells it to Brad for $15, securing a capital gain and a 50% return on investment. Best Coffee Company might also distribute a hypothetical profit of $20,000 to shareholders as dividend income.

3. Valuing a Business and Long-Term Movement

A business is worth its future profits evaluated through price-to-earnings ratios, while long-term stock prices inevitably follow corporate earnings rather than daily sentiment.

The price-to-earnings ratio divides a stock price per share by its earnings per share. This metric serves as a primary tool to compare how expensive or cheap different companies are.

If Best Coffee Company earns $1.00 per share annually, investors might agree that a fair share price is $10.00, establishing a P/E ratio of 10.

Valuing a Business

Your purchase price determines your ultimate return. Different purchase prices yield dramatically different results:

• $1.00: Annual earnings per share for Best Coffee Company in the baseline example.
• $2.00: A low purchase price yielding a 50% return.
• $10.00: A fair purchase price yielding a 10% return.
• $1,000: An extreme high purchase price yielding a 0.1% return.

Short-Term vs Long-Term Movements

In the short term, stock prices fluctuate based on investor optimism and pessimism. News events and daily sentiment shift the P/E ratio up and down to drive daily price volatility. Over long periods, sustained growth in earnings dictates the ultimate direction of stock and market prices.

Starbucks stock fell from $94.66 to $93.54 on November 12, 2020. The next day, it rose from $94.38 to $95.30 purely based on shifts in investor sentiment without any company news releases. Starbucks stock also fell from $68.83 to $57.67 in March 2020 following COVID-19 shutdowns. The broader S&P 500 reached a price level of 3,756 in 2020 compared to $4.44 in 1871.

Holding Period Probabilities

The probability of achieving positive returns in the stock market increases significantly as your holding period gets longer. While daily and monthly returns behave close to a coin flip, historical data shows that holding U.S. stocks for long enough guarantees a positive return.

• 52%: Odds that the S&P 500 goes up on any given day.
• 61%: Odds the S&P 500 goes up over a 1-month period.
• 66%: Odds the S&P 500 goes up over a 6-month period.
• 69%: Odds the S&P 500 goes up over a 1-year period.
• 20: The number of years in a holding period that has historically yielded a 100% positive return rate.

The S&P 500 has produced a positive return 100% of the time across every rolling 20-year holding period in history.

4. Market Crashes and Seven Forces of Earnings

Stock market crashes are a normal, unpredictable part of investing caused by human fear and expectations of declining earnings. When negative events happen in the world, investors worry that earnings will fall and rush to sell their stocks. This selling drives share prices down, creating momentum that feeds on itself until a crash occurs. Despite this, the stock market has always recovered as businesses innovate, weak competitors fail, and profits return to new highs. Historical records show that stock market crashes happen every decade or so across a 100-year span.

Market crashes are normal emotional events, whereas corporate earnings grow consistently over time due to seven powerful economic forces.

During a pandemic in Best Coffee Company's fourth year, store profits dropped from $20,000 to $2,000, causing the share price to plunge by over 85% from $30 to $4 before eventually recovering and reaching $30,000 by year 7.

Seven Forces of Earnings

While individual forces have a small impact in any given year, their combination ensures long-term profit growth. The typical yearly impact of each individual earnings-growth force is 1% to 2%.

These drivers include:

• inflation;
• productivity;
• innovation;
• international expansion;
• population growth;
• acquisitions;
• stock buybacks.

Inflation is the deliberate increase in goods and services prices caused by the gradual loss of money's buying power. The central bank aims to keep inflation around 2% per year by steadily raising the money supply. As money becomes more abundant, each individual dollar loses value, causing businesses to raise prices and increase their profits slightly each year. The Federal Reserve maintains this target annual inflation rate in the U.S.

McDonald's Big Mac cost $0.45 when launched in 1967 and rose to about $5 by 2020 due to inflation despite having the same basic ingredients.

Companies grow earnings and consolidate ownership by acquiring other businesses and repurchasing their own shares. Acquisitions allow a company to absorb another business's revenue and profits instantly. Stock buybacks reduce the total number of shares outstanding, increasing each remaining share's proportional claim on corporate earnings and assets. American businesses spent $2.4 trillion in 2020 to acquire more than 15,000 companies.

Amazon acquired Whole Foods in 2017 for $13.4 billion to instantly gain hundreds of physical grocery stores.

5. Compounding, Investment Vehicles, and Accounts

Compounding and dividend reinvestment build massive wealth when housed within tax-advantaged retirement accounts rather than high-fee mutual funds.

Power of Compounding

Compounding accelerates investment growth exponentially as investment proceeds are reinvested repeatedly over long periods. In the stock market, compounding works because price movements are tracked in percentages rather than points, and index percentage bases reset annually on January 1st. The S&P 500 achieved an approximate long-term compound annual growth rate of 10%.

Doubling $1 thirty times results in $1,073,741,824. Investing $100 per month in the S&P 500 starting from 1970 through the end of 2020 accumulated a total of $2,618,060.

Reinvesting dividends into additional shares significantly boosts long-term portfolio returns through compounding. When investors use dividend payouts to buy more shares, their share count increases, which generates larger future dividend payments and accelerates portfolio growth. The S&P 500 maintained a dividend yield of 1.5% at the end of 2020.

Aaron turned $400 per month into $3.03 million over 39 years. Without dividend reinvestment and by spending the dividends instead, his final portfolio would have been worth only $1,483,731. That difference meant 2.5% of Aaron's 11% compound annual growth rate came from reinvesting dividends.

Retirement Accounts and Mutual Funds

Retirement accounts offer tax advantages and employer matching contributions to incentivize long-term saving. Accounts like 401(k)s and IRAs provide either immediate pre-tax deductions or tax-free withdrawals in retirement, though they often impose penalties for early withdrawals before age 59½. Americans held a total of $6.9 trillion in 401(k) plans as of March 2021.

An employee earning $50,000 who contributes $3,000 to a 401(k) with a 50% match up to 6% receives an extra $1,500 in free money from their employer. The 2022 annual contribution limit for a standard 401(k) or Roth 401(k) for participants under age 50 was $20,500, while participants over age 50 faced a limit of $27,000. The 2022 annual contribution limit for an IRA or Roth IRA for individuals under age 50 stood at $6,000.

You can set up these structures by following specific setup and advisory guidelines:

• Open an account with a brokerage firm by filling out an online form and linking a bank account.
• Contribute to an employer-sponsored retirement plan to capture any available company match.
• Verify vesting schedules before leaving an employer to ensure retention of matched funds.
• Ask potential advisors if they are a fiduciary bound to put client needs first.
• Check for industry credentials such as CFP or CFA designations.
• Inquire about their fee structure, prioritizing fee-only arrangements over commission-based models.
• Interview at least three different financial advisors before making a hiring decision.

The vast majority of mutual funds underperform index funds due to structural handicaps like fees, misaligned incentives, and career risk. Mutual fund managers face career risk that discourages unconventional strategies, forced diversification limits, and high expense ratios that drag down returns. Consequently, 89% of mutual funds underperformed the stock market between 2004 and 2019.

Mutual funds charged an average expense ratio of 0.66% in 2019, whereas index funds charged an average expense ratio of 0.13%. Financial advisors charge an industry standard fee range of 0.50% to 1.25% for assets under management, common hourly fees between $100 and $400, and typical fixed fees of $1,500 to $3,000 for a complete financial plan.

6. Advisors, Psychology, and Portfolio Construction

Successful investing requires vetting advisors, avoiding market timing, maintaining strict asset allocation, and practicing dollar-cost averaging.

Evaluating Advisors and Robo-Advisors

Investors must carefully vet their financial advisors to ensure they act as fiduciaries, charge transparent fees, and educate rather than confuse. The author outlines five key questions to evaluate an advisor: whether they disclose their fees, whether they educate or confuse with jargon, if they adhere to the fiduciary standard, if they communicate adequately, and how portfolio performance compares to an appropriate benchmark rather than in a vacuum.

• Ask how the advisor gets paid and check for hidden fees.
• Determine if they communicate clearly or use confusing industry jargon.
• Verify whether they are a fiduciary who puts your interests first.
• Evaluate their communication frequency.
• Compare your asset performance against an appropriate benchmark instead of looking at portfolio growth in a vacuum.

Robo-advisors offer automated, low-cost investment management through index funds and algorithms, making them accessible with low minimums. Robo-advisors use computer algorithms to build and maintain portfolios, automatically rebalancing and optimizing for tax efficiency. They typically charge expense ratios between 0.2% and 0.5% annually, which is less than half the rate of human advisors, though they lack human advisory support. Popular robo-advisors listed include Acorns, Betterment, Bloom, M1 Finance, Personal Capital, and Wealthfront.

Market Psychology and Timing

Investing during economic downturns yields superior long-term returns because stocks become cheap due to contracted P/E ratios. When the economy is struggling and unemployment is high, stock prices and P/E ratios drop significantly, which sets the stage for higher future returns. Conversely, when the unemployment rate is low, the market is expensive and future returns tend to be lower. S&P 500 returns are highest when the unemployment rate is above 9%, whereas returns are lowest when the unemployment rate is under 5%. During the 2008 U.S. financial crisis, large banks failed and stock markets plunged.

Attempting to time the market is virtually impossible in real time because short-term prices are driven by unpredictable collective investor emotions. Timing the market requires being right twice: knowing exactly when to sell before a drop and knowing when to buy back before the recovery. Historical back-testing makes highs and lows obvious, but real-time execution fails because market prices reflect shifting human emotions. The S&P 500 grew from 1,469 to 3,756 between January 2000 and December 2020 through severe bubbles and crashes, delivering a 156% total return. An uninterrupted 14-year bull market between March 1982 and December 1996 consistently fooled investors into selling early as the index moved from 1,469 to 741.

Penny stocks signal underlying business trouble, and selling winning investments prematurely destroys long-term compounding gains. Stocks trading below $5 often reflect unprofitable or cash-strapped businesses. Furthermore, rushing to take profits when a great investment rises prevents investors from capturing massive multi-decade gains in winning companies. The author purchased Dexcom stock at $6.67 per share in 2007 due to its promising continuous glucose monitoring technology, but sold it prematurely at $7.69 per share, missing out on the stock reaching $403.67 by the end of 2020. Extremely high dividend yields are often a warning sign of a troubled company rather than a safe income strategy. Dividend yields rise when a company's share price collapses because investors fear the business can no longer afford the payout. Buying stocks purely for high yields frequently leads to a double-whammy of falling share prices and slashed dividend payments, such as the 10%, 15%, and 20% high dividend yields initially targeted by the author that indicated distressed companies.

Asset Allocation and Dollar-Cost Averaging

Asset allocation optimizes the mix of stocks, bonds, and cash for risk and reward, while regular rebalancing realigns portfolio weightings. Asset allocation balances an investor's goals, time horizon, and risk tolerance across stocks, bonds, and cash. A common age-based rule of thumb is subtracting age from 110 to determine the target stock percentage. Over time, uneven asset growth unbalances the portfolio, requiring periodic rebalancing to maintain target allocations. An initial 50/50 portfolio of $100,000 in stocks and bonds grows to $200,000 and shifts to 70% stocks and 30% bonds, requiring the sale of $40,000 in stocks to purchase bonds and restore the 50/50 split.

• Subtract your age from 110 to find an approximate target percentage for stock allocation.
• Review and rebalance your portfolio on a fixed schedule, such as every year, to maintain your target asset mix.

Market conditions cycle through bull markets, bear markets, corrections, and sideways markets, while bonds provide lower volatility and fixed income. A bull market represents a 20% or more rise from recent lows, a bear market is a 20% or more drop from recent highs, a correction is a 10% drop, and a sideways market reflects stable trading ranges. Bonds act as fixed income debt securities issued by entities to pay fixed interest rates, offering lower returns than stocks in exchange for significantly lower volatility. Dollar-cost averaging eliminates market timing anxiety, while employee stock purchase plans and vesting schedules reward long-term employment. Dollar-cost averaging involves investing fixed dollar amounts at regular intervals regardless of market prices, automating long-term success. Aaron turned $400 per month into over $3 million using automated dollar-cost averaging. Additionally, Employee Stock Purchase Plans let workers buy discounted company stock via payroll deductions with up to a 15% discount or look-back provision threshold, while vesting periods and equity compensation align employee tenure with company growth over the most common 3 to 4 year vesting period for 401(k) matches and stock compensation.

• Set up automated recurring contributions to your investment account to practice dollar-cost averaging.
• Review the rules, discounts, and look-back provisions of any employer ESPP or vesting plan before participating.

The Federal Reserve and the SEC regulate the monetary system and markets, whereas stock splits adjust share counts without altering company value. The Federal Reserve, created in 1913 by the Federal Reserve Act, manages interest rates to maximize employment and maintain price stability. The Securities and Exchange Commission was created in 1934 under the Securities Exchange Act to enforce financial laws and protect investors. Meanwhile, stock splits increase the number of shares and lower individual share prices proportionally without creating or destroying any underlying company value. Best Coffee Company executing a 2-for-1 stock split doubles its share count from 20,000 to 40,000 while cutting the share price from $100 to $50, leaving total ownership value completely unchanged.

10 Key Ideas

1. Brian Feroldi argues in Why Does The Stock Market Go Up? that the market is history's greatest wealth creation machine.
2. A stock represents fractional ownership in a corporation, giving shareholders legal claims on company assets and profits.
3. A business is worth its future profits evaluated through price-to-earnings ratios, while long-term stock prices inevitably follow corporate earnings rather than daily sentiment.
4. In the short term, stock prices fluctuate based on investor optimism and pessimism, driving daily price volatility through shifts in the P/E ratio.
5. The probability of achieving positive returns in the stock market increases significantly as your holding period gets longer, with historical data showing 20-year periods yield a 100% positive return rate.
6. Despite market crashes being normal emotional events caused by human fear, the stock market has always recovered as businesses innovate, weak competitors fail, and profits return to new highs.
7. While individual forces have a small impact in any given year, the combination of inflation, productivity, innovation, international expansion, population growth, acquisitions, and stock buybacks ensures long-term profit growth.
8. Compounding accelerates investment growth exponentially as investment proceeds are reinvested repeatedly over long periods, and reinvesting dividends into additional shares significantly boosts long-term portfolio returns.
9. Attempting to time the market is virtually impossible in real time because short-term prices are driven by unpredictable collective investor emotions that require an investor to be right twice.
10. Dollar-cost averaging eliminates market timing anxiety by involving fixed dollar amounts invested at regular intervals regardless of market prices, automating long-term success.