The Stock Market Simplified

I’ve been thinking a bit about the stock market lately as my daughters are taking a summer course on the financial markets.

For the general public, the explanation is pretty standard: The stock market reflects the growth of the economy. Even people who dedicate their lives to understanding the details don’t necessarily do any better than a monkey with the dartboard. Thus, the average person should invest in broad index funds, re-balance over time, and don’t react when the market has wild swings (which I agree with and do myself).

The other view is that, if you understand the markets and companies well enough, you can identify winners (or “find alpha” as the cool kids say). To do so, you need to be able to read a balance sheet, understand financial ratios, have an opinion on the federal funds rate (first knowing what that actually is and what impact it has), and a virtually infinite number of other potential strategies that *might* work to get you an edge.

The course my daughters are taking is covering all the basics of the second view. I think it’s incredibly valuable to understand how this machine works, but as you can imagine, they (being 14 and 17 years old) were getting a bit overwhelmed with the detail.

So I sketched a quick 2×2 grid to help them zoom out. Cleaned up, it looks like this:

In a nutshell, the stock market is a large number of people placing bets against what the dominating “current narrative” says compared to what they think dominating “future narrative” will be. Note that I didn’t say future reality. The market is fundamentally a battle of narratives, sometimes supported by facts, sometimes not. Facts tend to win in the end, but they can be out of whack for quite a while (see 2008). Besides, reality is subjective. In the end all we have are narratives.

So the ultimate investing question is “what do I believe the future narrative will be and how strongly do I believe it?” The stronger the belief, the bigger the bet.

Which, by the way, just happens to be the same question you need to answer for every big decision in life.