Posted about 1 year ago

Is the Stock Market Fair?

I bought my first stock when I was in 6th grade, at 12 years old. I had saved $1,000 in my bank account and purchased 50 shares of American Electric Power (AEP) at $20/share. After a few years AEP’s stock had jumped to $50/share so I sold all my stock, making a nice 150% profit.

I wish I could take the credit for this great stock trade, but it was under the guidance and supervision of my father. Nonetheless, I was introduced to a whole new way to make money, by letting your money work for you. Wealthy people don’t work for their money they let their money work for them. The stock market is one of several avenues to get your money working for you.

So, what exactly is the stock market? For lack of a better description, it’s a place where thousands of companies are bought by everyone from large institutions, like banks and hedge funds, to small investors, like you and me. Companies need money to grow so they offer stock, either privately or publicly, to investors. When an individual buys the stock (shares) he/she owns a small portion of the company, and thereby owns a share in the earnings. With better earnings and growth in the company the stock price should increase due to basic supply and demand. The company that is performing better should draw more investors, rising demand and subsequently driving the price of the stock higher.

I say should because what I just told you is readily available by a simple Google search of “how the stock market works’”, in better detail too, but what people don’t tell you is the market doesn’t really work that way. It’s supposed to but it doesn’t. There are huge hedge funds buying and selling millions of shares a minute in the stock market, far more than you or I can imagine. This can artificially inflate/deflate the stock price because the hedge funds have created a lack/excess of supply, driving the price up/down.

Then you have high frequency traders (HFTs) who buy shares in fractions of a second before a stock rises, and subsequently sells before the stock price falls. HFTs can buy faster than any human can read company news, let alone decide whether to buy or sell. They have developed complex algorithms, installed hundreds of millions of dollars’ worth of fiber optic cables, and the worst part, its LEGAL. Check out this 60 Minutes episode on HFT.

So ‘they’ tell you to invest with a broker who knows how to protect you from buying the declining stocks and help you make the most of your investments. The truth of the matter is they don’t know what’s going on either! Sure, they may sit and read quarterly earnings reports and watch several market indicators, but they have no idea what the market is going to do today, let alone tomorrow.

You can even try to follow or mimic the analyst’s stock picks with no avail. First let me explain what analysts are; each hedge fund or large investment company has analysts that follow a particular company. The analysts are supposed to understand that company inside and out, to estimate the company’s quarterly earnings, and understand the overall health of the company’s business. They sound like a reliable source, right? I mean who can possibly know more about a company than a person whose sole job is to analyze that company’s business? The answer: it doesn’t matter how much he knows about the company. Analysts make erroneous estimates every single day. Credit Suisse, a respectable financial services company, reiterated their buy in Enron a week before the company went bankrupt, one week!

Let’s recap on what we’ve learned so far:

  1. - Wealthy people don’t work for their money they let their money work for them. One avenue to accomplish this is the stock market.
  2. - The stock market is a place where you can buy a share in a company’s profitability and growth.
  3. - The stock market has several pitfalls:
  4. - Hedge funds are buying massive quantities of stock, which can manipulate the stock prices
  5. - HFTs are stealing millions of dollars because they can trade stocks faster than any human, and it’s legal
  6. - Stockbrokers and analysts really don’t know what the stock market is going to do today, let alone tomorrow.

So, what’s a guy to do who wants a piece of the double-digit growth in the S&P 500? You’ll have to check out this post!