What are the Dangers of Investing in the Stock Market?
When people try to explain the dangers of markets, they use works like “risk,” “volatility,” and “time horizon.” Compliance offices love those words. They sound tame, despite the fact that they don’t really do justice to the underlying message that actually answers the question of what dangers exist in the stock market. So here’s the simple answer:
You could lose all of the money you invest very quickly if you invest in the stock market.
Here’s why. When you own stock in a publicly-traded company, you own a percentage of the future cash flows of that company. And just like your budget for your household, cash flow is the difference between how much you earn and how much you spend. Earn $100 and spend $80, and your cash flow is $20. Earn $80 and spend $100, and your cash flow is -$20. So when you make the decision to buy stock in a company, you are effectively betting on one of two things happening – the company’s cash flows are going to go up over the time period in which you own it, or other people think the company’s cash flows are going to go up over that time, and the price will be bid up even though the underlying company may or may not be improving.
That’s what happens if everything goes right. The problem is that just like people have bad days, weeks, or months, companies can have those, too. And when companies string together enough bad weeks or months in a row, it can result in big changes to the stock price. And typically not in the right direction.
Let’s say that you bought shares in Company X. You really liked the fact that they were going to change the world, you believed in their mission, and you loved their product and had three of them. And you also got them for your parents, but they just threw the box in the basement with all the other gifts they don’t need. When you buy the stock, they’re selling 75 units of their product each day, but after the first quarter, they’re up to 100 units per day. Things are good at Company X. They’re growing like a weed. Investors love their growth and think they can generate bigger profits in the future. But then Company Y gets into the exact same business and has a better product than Company X. Company X goes from selling 100 units of their product every day down to 50 per day, and they also have to discount them significantly in order to sell them. This has two meaningful effects on the stock price.
What can go wrong with investing in stocks?
First, the company’s projected cash flows change negatively in a meaningful fashion. They are selling half as much product as they used to, and they’re not selling those products for the same price as they used to because of the discounts they had to offer in order to entice new buyers. So the first piece of the stock price puzzle is hurt by the material changes to the company’s business.
But just as importantly, investor perception of the company changes as well. Investors who were previously bullish on the company’s ability to growth their cash flow and profits in the future now feel that the company no longer has that potential. It still may. Remember, other investors aren’t always right, just like you weren’t necessarily right when you bought the stock originally. So this does not mean that you need to sell the stock when it’s down. But it does mean that the stock may not just fall as much as the projected decline in cash flow or profits. Instead, it may fall more because the growth premium investors had previously given the company has now turned into a growth discount since investors don’t know if it’s going to be able to get back to those levels again.
The mechanics that you see for a single company here can be extrapolated to companies within a sector, or even a market index. Because things can change so quickly for companies, it is generally not a good idea to invest in stocks if you need access to the money you are investing in the next one to three years. Stocks can be incredibly volatile over short periods of time, and there are likely more stable instruments for you to use if you have a need to access that cash in the near future. Stocks can have a lot of upside if you look at them with a long-term view and remain patient through the ups and downs. But if you need something reliable over a short time period, stocks are likely the wrong choice for you. After all, you could lose a portion or all of your investment at the drop of a hat. And that’s going to leave your head cold in the winter.