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The Need to Invest: Time Value of Money Concept
The concept of Time Value of Money (TVM) is a fundamental principle in finance. It suggests that money today is worth more than the same amount in the future because money can earn interest or grow when invested. For example, if you invest $1,000 today at a 7% annual return, after one year, it will grow to $1,070. But if you wait a year to invest, you miss out on that growth. Over time, this effect can become significant, as returns compound.
This is why starting to invest early is crucial. By investing now, you allow your money to grow over time, building wealth for the future. The longer you wait, the less time you give your investments to work for you. Whether saving for retirement, buying a home, or funding education, the earlier you start investing, the more likely you are to achieve your financial goals.
One of the ways to invest is the stock market. For today, tomorrow, and the decades ahead, the stock market remains a powerful foundation for building generational wealth. It provides individuals with the opportunity to buy ownership stakes in companies, allowing them to benefit from their growth and profitability. Over the long term, investing in the stock market has historically offered one of the best returns compared to other types of investments like bonds, cryptos, or savings accounts.
What is the Stock Market?
The stock market is an organized and regulated marketplace where investors buy and sell shares of publicly traded companies. From a scientific perspective, the stock market functions as a dynamic system, where the interactions between various market participants, such as investors, traders, and brokers, determine the price of a company’s stock based on the collective decisions of the market.
The stock market acts as an intermediary that facilitates the exchange of ownership of stocks. If you wish to buy a share in a company, you can do so by purchasing it from another investor through the stock market. This exchange of ownership helps establish a market price for a company’s shares, driven by the forces of supply and demand.
The concept of a market is rooted in economic theory and refers to the aggregation of buyers and sellers, each with their own expectations, knowledge, and motives. The efficient functioning of the market relies on the ability of the stock exchange to match buyers with sellers, much like how the law of supply and demand works in other economic systems, such as the commodities market.
In the U.S., major stock exchanges such as the New York Stock Exchange (NYSE) and NASDAQ facilitate these transactions. These exchanges have evolved to be primarily electronic, allowing investors to trade stocks from virtually anywhere in the world, using the internet and various brokerage services.
How Do Stocks Move?
Stock prices fluctuate in response to numerous factors that include company performance, market sentiment, economic indicators, and news events. At its core, these movements can be understood scientifically through market psychology, which reflects the collective behavior of investors reacting to new information.
For instance, if Apple Inc. announces a leadership change and senior executives leave, the stock price might decline because investors are uncertain about the company’s future direction. If some investors believe that the leadership change will cause long-term harm to Apple, they may sell their shares, thereby increasing supply and causing the price to fall. Conversely, other investors may believe that the leadership change presents an opportunity for growth, increasing demand, which would push the price higher.
This behavior can be modeled using game theory or behavioral economics, which studies how individuals make decisions in interactive environments, where the outcome depends not only on their choices but also on the choices of others. The interactions in the stock market can lead to various market equilibria—states in which supply and demand balance.
The Efficient Market Hypothesis (EMH) is a key concept in understanding how stock prices move. It suggests that at any given time, stock prices fully reflect all available information. This means that it’s impossible to consistently "beat the market" by using any information that’s already public because the market has already priced that information into the stock.
In an efficient market:
All news, announcements, and reports are quickly incorporated into stock prices.
No investor can gain an advantage by using public information because the market adjusts immediately.
Stock prices move randomly, reflecting only new, unexpected information.
To illustrate this further, let’s consider a scenario where Apple announces that they have appointed a new CEO. The information may be interpreted in various ways by market participants:
Some investors may perceive the leadership change positively, driving up the demand for shares (buying pressure).
Others may view it negatively, anticipating disruption, and thus increase the supply by selling their shares.
The result is a shift in equilibrium, where the balance of buyers and sellers sets a new market price. This process is a fundamental part of how stock markets work.
How Does the Stock Get Traded?
In the stock market, an order is a request to buy or sell a stock, and the process of matching buyers with sellers happens via order matching algorithms. These algorithms are designed to ensure that trades are executed at the best possible prices, which reflects the efficient market hypothesis. Here's a breakdown of the process:
Placing an Order: When you wish to buy a stock, you place an order through your broker, specifying the stock symbol (e.g., AAPL for Apple), the number of shares, and the price you are willing to pay.
Broker Verification: The broker checks to ensure you have the necessary funds or margin to execute the trade.
Order Matching: Once the order is verified, it is sent to the stock exchange. The exchange matches your order with a seller’s order at the agreed price.
Execution and Settlement: After the trade is executed, the shares are electronically transferred to your brokerage account.
This efficient, algorithmic system ensures that transactions occur seamlessly and swiftly. Once you own stock, you are considered a shareholder in the company. Scientifically, this means you hold a fractional ownership of the company, proportional to the number of shares you own. For instance, owning 200 shares of Apple means you own a tiny fraction of the company’s total outstanding shares.
As a shareholder, you may be entitled to certain corporate benefits like dividends, stock splits, and voting rights at shareholder meetings. These entitlements are part of a system designed to align the interests of shareholders with the company's long-term health.
The value of your stock will continue to fluctuate based on how the company performs, as well as the broader market and economic conditions.
Calculating Returns
Returns show you how well your investments are performing and help you assess whether your strategy is effective. But not all returns are calculated the same way. Let's explore the different methods used to calculate returns, understand how they work, and discuss which might be the best for you.
Absolute Return
Absolute Return is the most straightforward way to measure the performance of your investment. It calculates the percentage change in the value of your investment over a specific period of time, usually from the purchase to the sale of the stock.
In this case, your investment grew by 20% over the time you held the stock.
Pros:
Very simple to calculate and understand.
Useful for comparing short-term investments or different investments made at the same time.
Cons:
Does not account for the time it took to earn the return. Two investments with the same absolute return might take different lengths of time to achieve, and the one that took longer might have been a worse investment overall.
Compound Annual Growth Rate (CAGR)
While absolute return gives you a basic understanding of how much your investment grew, it doesn’t consider the effect of compounding—the process where earnings on your investment generate their own earnings. The Compound Annual Growth Rate (CAGR) is a more sophisticated measure that accounts for compounding and the time value of money. It shows you the annual growth rate of your investment, assuming the growth happens at a steady rate over the investment period.
This means that, on average, your investment grew by 14.47% per year over the 3-year period.
Pros:
Accounts for the effect of compounding, making it a more accurate measure of growth over time.
Useful for comparing long-term investments, especially when investments are held for different periods.
Provides a consistent annual growth rate, making it easy to compare multiple investments.
Cons:
It assumes a constant growth rate, which isn't always realistic since investments can grow at varying rates from year to year.
Does not account for fluctuations or volatility in returns over the investment period.
Risk-Adjusted Return
Investing isn't just about how much you can earn—it's also about how much risk you’re taking on to earn that return. Risk-adjusted return helps investors understand whether the returns of an investment justify the risk. The Sharpe Ratio is one of the most popular ways to measure risk-adjusted return.
The Sharpe Ratio compares the return of an investment to its risk, using the standard deviation of the investment’s returns as the measure of risk.
A higher Sharpe ratio indicates a better risk-adjusted return.
Pros:
Helps you evaluate the quality of your return by factoring in the risk you took to achieve it.
Useful for comparing different investments that may have different levels of risk.
Cons:
Requires more complex data (like the standard deviation of returns).
Only useful for comparing investments with similar time horizons and risk profiles.
The right way to calculate returns depends on your investment goals, time horizon, and risk tolerance. Here’s how to choose the best method:
Short-Term Investors or Traders: If you're trading stocks over short periods, the absolute return will give you a quick snapshot of how your investment performed. It’s simple, easy to track, and useful for quick comparisons.
Long-Term Investors: If you're planning to hold investments for years, the Compound Annual Growth Rate (CAGR) is likely the most important tool for you. It smooths out the volatility and gives you a clearer picture of how your investment grew annually, factoring in compounding.
Dividend Investors: If your strategy involves collecting dividends, you should consider total return, as it accounts for both the appreciation in stock price and the dividends you received during the investment period.
Risk-Averse Investors: If you’re concerned about the risks associated with your investments, use risk-adjusted returns like the Sharpe Ratio. This allows you to assess whether the returns justify the level of risk you're taking on.
The Role of Risk and Time Horizon
Risk is inherent in investing, and understanding it is key to managing your portfolio. In scientific terms, risk refers to the chance that your investment will not perform as expected. Stocks tend to be riskier than bonds or savings accounts, but they also have the potential for higher returns.
Your time horizon—the length of time you plan to keep an investment—affects how much risk you should take. If you’re investing for a short-term goal (like buying a car), you may want to take less risk. For long-term goals, like retirement, you might be more comfortable with higher risk, as it allows you to ride out market fluctuations.
Where Do You Fit In?
As an investor, you can take different approaches based on your goals, risk tolerance, and time horizon. Some common strategies include:
Long-Term Investors: These investors typically focus on holding stocks for years or even decades. They believe that, despite short-term volatility, the stock market will provide positive returns over the long run. Investors like Warren Buffett follow this strategy, choosing companies they believe will grow over time.
Short-Term Traders: Traders buy and sell stocks over shorter periods, often trying to profit from market volatility. This strategy requires more attention and a willingness to accept higher risks.
Looking Ahead: Volume II
This concludes our foundational exploration of investments, returns, and the essentials of the stock market. Next week, in Volume II, we will dive deeper into the scientific approach to fundamental analysis of stocks. We'll explore how to evaluate a company's intrinsic value, analyze financial statements, and identify the right stocks to build a robust investment portfolio. Stay tuned for practical strategies and tools to enhance your investing journey!
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