🍞 Demystifying Finance: An Intro to Stocks
Navigating the World of Finance: From Ancient Beginnings to Modern Markets
🥯 This edition of the Big Baguette is brand spanking new. In 2023, the Big Baguette will be going deep on a specific topic each month. This month’s topic…Money & The Stock Market!
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Hey, Loyal Bread Crumbs People 👋🏻
As you read above, we are switching up the Big Baguette format. This year, we will be writing fewer posts (~1 per month). By pruning quantity; we will increase quality. Each Big Baguette will go deep on a topic we find compelling and think you’d enjoy learning about. Our goal is to have each edition improve your mental, physical, or financial fitness. These categories are guide posts, not rules. If we find a topic particularly compelling, we will write about it whether or not it hits on one of those three themes.
Our aim for the reading time is somewhere between 5-10 minutes. A quick Sunday night read to set you up for a successful week. With that, let’s jump in.
Demystifying Finance: An Introduction to Stocks
Hey Everyone, it’s Paul. I know I’ve been MIA since April. I’ve been super busy. When someone tells you they’ve been too busy, all that means is you are not the priority. That was the case here. I didn’t prioritize writing when I should have. I apologize for letting you down. However, I wanted to share a few exciting life updates: (1) I moved in with my girlfriend (and loyal reader) Kate (2) I hosted the first-ever in-person event for YM2. Thanks to those who attended, gifts are coming! (3) I traveled over 9,200 miles and visited NYC, Seattle, Vancouver, Boise, Centralia, and Champaign.
Enough about me: This newsletter is for you! This month’s edition is the 1st in a 3 part series. It’s a bit different than previous essays. I’ll be talking about money! What’s money got to do with your mental health? Well, a lot actually!
What’s been bothering you recently? Think you deserve a better salary? Money! Annoyed about the price of groceries? Money! Nervous about student loans? Money! Like 66% of adults in America are having panic attacks over money problems. Mental health and financial health are intertwined. That’s a win for me, baby! Because the two things I’m obsessed with, besides Kate, are finance and mental health.
So, how am I going to help you? Over the next 3 essays, I’ll show you that money is a tool. It can be used for good and bad. Our focus will be on saving and investing. More specifically, investing in the stock market. Finance bros worldwide LOVE making people feel stupid. I’m not going to do that. I’m going to teach you the fundamentals. The fundamentals are 80% of the battle. To master the fundamentals, we need to go back to the beginning…
A Brief History of the For-Profit Business Model
Welcome to Amsterdam circa 1602. Wait, I f*cked this up. I need to bring you to Ancient Mesopotamia first. Let’s try that again. Welcome to Ancient Mesopotamia circa 4,000 BCE. As you walk the streets here, you will see vendors and merchants trading goods like cloth, metals, and spices. Look closely! You’ll notice something special - the smartest traders buy goods at a discount and sell them at a premium. That difference…profit!
Our Mesopotamian ancestors invented the first for-profit business model. Many of these dudes operated alone. They were the only shareholders and owned 100% of the business. A shareholder is someone who owns part or all of a for-profit business. If a business were a pie, each individual piece would be a share. Each share represents a certain ownership percentage. If the pie has 10 pieces and I have 3, I own 30% of the pie or 30% of the business.¹ I get 30% of the future profits the business makes. In our example, the Ancient Mesopotamian trader is entitled to 100% of the future profits his business makes. He owns the whole pie!
If he evenly split the business with 3 of his Mesopotamia homies, each guy would own 33.3% of the pie. So, if they made a $100 profit from trading, each dude would get $33.3. Being an owner gets you some sweet privileges. Being an employee, not so much.
Most employees are not owners. Employees get a salary and maybe a little bonus. But for the most part, you have no upside as an employee. If the business generates huge profits, you get (wait for it) nothing more than your salary. Sad! That’s the downside of not being an owner. You only get payment for your labor. We will discuss the downsides of being an owner some other time.
It is very rare to get stupid rich from just making a salary. Most billionaires are not employees, they are owners. Owners don’t typically make a billion dollars in salary. They own a piece of a business and that business happens to be worth billions! If a billionaire’s business is valued at $100 billion and she owns 1% of it, she is technically a billionaire.
💡 Before we leave Ancient Mesopotamia and enter Amsterdam circa 1602, let's do a quick recap:
If you sell something at a price higher than what you paid for it, you make a profit
Ancient Mesopotamian traders figured this out and became the first for-profit businessmen
All future profits of a business are for the owners. Ownership can be broken down into individual shares. Most employees do not own shares in the company they work for.
Being a billionaire doesn’t mean you’ve got billions of cash in the bank. It likely means that your % ownership in a company is worth a billion dollars
The Invention of the Initial Public Offering
Now, back to 1602 Amsterdam. Something very special is happening. A trading company, the Dutch East India Company, is setting off on an expedition. They will sail to Indonesia, steal buy exotic spices, and sell them for a profit in Europe. They use the same playbook as the Ancient Mesopotamians.
The difference between the Mesopotamians and the Dutch was scale. The Dutch were going BIG. They needed thousands of ships and tens of thousands of employees. Usually, they would raise money from rich Dutch people to build ships and hire employees. But even the richest Dutch people didn’t have enough money to finance building thousands of ships and hiring tens of thousands of employees. So, the Dutch East India Company offered shares to all the Dutch people.
The charter stated the following:
“All of the residents of these United Provinces shall be allowed to participate in this Company and to do so with as little or as great an amount of money as they choose.” – Charter of the Dutch East India Company, 1602
The deal struck between the public and the Dutch East India Company went something like this…
“Give me some of your money. I’ll build ships and hire people with that money, I’ll sail to Indonesia and
stealbuy a bunch of spices. When I come back and sell those spices in Europe for a higher price than Istolebought them for, I’ll give you some % of the profits I make.” -Probably the Dutch East India Company Management Team, 1602
Each shareholder was entitled to a percentage of the future profits created by the Company. The only problem was, the Dutch East India Company couldn’t go door to door asking citizens for money. The Company needed a central location to bring all these potential investors together. That’s when the Amsterdam Stock Exchange said “hold my beer”.
The exchange did 2 things:
It gave the founders of the Dutch East India Company access to a centralized pool of investors.
It gave the initial investors a secondary market to sell their shares to other investors.
Today, stock markets function much the same as in Amsterdam. The New York Stock Exchange (NYSE) is the largest and most sophisticated exchange in the world. If you want money for your Company, you go to the NYSE and tell them something like…
“If you can bring a bunch of investors together to buy my shares, I’ll pay you a fee for doing that and will make you the primary place to trade my Company’s shares.” -Probably companies going public
The people who buy these initial shares may eventually want to sell them. Maybe they want to buy a house. They need cash to do that. To get cash, they can sell their shares. They’d name a price and the NYSE would find them a willing buyer. They’d sell the buyer the shares and the buyer would give them cash. The transaction price between the buyer and seller is the public company’s stock price. Asking the general public for money and in exchange giving them shares in your Company is called an Initial Public Offering “IPO”. The Dutch East India Company was the OG IPO.
The Madness of the Market
One massive change in stock market dynamics and IPOs was the shift from physical to digital exchanges. The rise of computing has, over the last 30 years, changed the buying and selling process. Before 1995, you had to deal with this madness like this picture. Today, you log into a website, set your buy or sell price, and click a button.
💡 We’ve covered a lot in the last few paragraphs, so let’s recap:
The first for-profit business was created in Ancient Mesopotamia
Shares in a for-profit business equal ownership and ownership equals a right to future profits
The Dutch East India Company was the first publicly traded company in the world
A publicly traded Company is owned by the public (you and I) and those ownership shares, called stocks, are traded on exchanges. The price a buyer and seller transact at is the stock price
Over the last 30 years, stock markets moved from the physical to the digital world
Congrats! You just learned more than I did in 4 years of studying Finance at the University of Illinois! At this point, you’re likely wondering, “Where can I get access to publicly traded companies?”
We get access to the public markets via a mystical character, the stockbroker. A stockbroker is an individual who is registered with the Securities and Exchange Commission “SEC”. Side note, the SEC is a government entity that oversees all financial markets in the U.S. The SEC is mandated to do 3 things:
(1) Protect investors
(2) Maintain fair, orderly, and efficient markets
(3) Facilitate capital formation…this means helping companies and entrepreneurs access the U.S. capital markets to help create jobs, develop life-changing innovations and technology, and provide financial opportunities to those who invest in them.
The SEC is the sheriff of finance town. If one of these stockbrokers breaks the securities law, the SEC takes him down. They can take down an individual stockbroker or an entire brokerage house. A brokerage house is a Company where a lot of stockbrokers work. Jordan Belford was a stockbroker, Straton Oakmont was a brokerage house.
Stockbrokers and brokerage houses are just a middle man. We tell them to do 2 things:
(1) What stock (i.e. Apple) we want to buy (or sell)
(2) What share price (i.e. $100) we want to buy (or sell) the stock at
The stockbroker will go to the exchange and buy the shares. Then, they transfer the shares to us and we pay the stockbroker for the cost of the stock purchase plus a fee for their labor. Here’s a simple diagram for my visual learners out there:
Let me make one thing CRYSTAL F*CKING CLEAR. Stockbrokers DON’T HAVE SKIN IN THE GAME. Let me say that again, stockbrokers DON’T HAVE SKIN IN THE GAME. They don’t care how you do. They make money every time you make a sale or purchase.
So, the more you trade, the more money they make. These people are incentivized to keep you buying and selling. Don’t be fooled into day trading. If you do that, stop reading this newsletter because you’re an idiot, a degenerate gambler, or both. I can deal with degenerate gamblers but not idiots.
Lucky for all my non-idiots, discount stock brokerage firms exist. These firms charge very low fees (like 1 cent per trade) and they won’t be pushing you to buy or sell. I personally use Vanguard but TD Ameritrade and Fidelity are also reputable firms. We will cover how to set up an investment account, deposit money into it, and purchase stocks in the final essay of this series. Before we do that, let’s break down what a stock is and why it goes up and down all the time.
Why Stocks Go Up & Down
If you turn on CNBC, you will see something that looks like this:
or this
or this
Stock prices are like me in high school. One week they’re cool, the next week they’re lame. The stock market and high school are both popularity contests. If more people want to hang out with you, the cooler you are. If more people want to buy your shares, the higher your stock price.
It’s supply and demand, my friends. A stock price is the price a buyer and seller are willing to transact. When buyer demand > seller supply, the stock price goes up. When buyer demand < seller supply, the stock price goes down. It’s true in the stock market or the art market. When you have buyer competition (buyer demand > seller supply), the price goes up!
The stock market’s volatility is a consequence of human nature. The stock market represents the public’s short-term perception. And in the short term, we love to panic. When we panic because of good news, we buy stocks at any price. When we panic because of bad news, we sell stocks at any price. When lots of humans sell stock, the price of that stock falls dramatically (buyer demand < seller supply). When other humans see the rapid price drop, they panic and sell. The cycle compounds and accelerates…creating a crash.
Eventually, enough people realize the panic is overblown. They start to buy the stock. As the stock price increases (or stabilizes), more people want in on the action. That change creates more interested buyers. As more people buy, the price continues to rise (buyer demand > seller supply). This cycle continues until there is a positive panic. People don’t think the stock will ever go down again!! That optimism continues until there is another negative panic and the cycle shifts and repeats.
One hack for all of this madness is to set rules for yourself. These rules force you to take a longer-term view. Long-term thinking creates better decision-making. People who make good decisions, lose less money.
For example, one view is that the United States, over our lifetime, will continue to create technological breakthroughs and U.S. companies will capitalize on this innovation and become more valuable. Once they become more valuable, people want to own their shares. In the future, you can sell those shares at a price higher than you bought them for.
With this view in mind, you have no reason to panic when a stock goes down today or up tomorrow. Individual stocks will go up and down in the short term but so long as the U.S. continues to be a strong economic force, U.S. companies and their owners (stockholders) will become more valuable. For that reason, I buy Exchange Traded Funds “ETFs” that represent the largest 500 companies in the U.S. We will cover ETFs in the final essay of this series. In short, ETFs allow you to buy a basket of stocks that represent shares in the largest companies in the U.S.. By having a basket of stocks, you aren’t necessarily betting on one company but hundreds of the largest U.S. companies that exist or will exist. So, when should you start buying ETFs?
💡 Before we go into buying ETFs, let’s recap all that we’ve learned so far:
The first for-profit business was created in Ancient Mesopotamia
Shares in a for-profit business equal ownership and ownership equals a right to future profits
The Dutch East India Company did the first-ever Initial Public Offering “IPO” and was the first ever publicly traded company.
A publicly traded Company is owned by the public (you and I) and those ownership shares, called stocks, are traded on exchanges
Over the last 30 years, stock markets moved from the physical to the digital world
We can buy (or sell) stocks via a stockbroker
Stock prices reflect the supply and demand of buyers and sellers
If buyer demand > seller supply, the stock price rises
If buyer demand < seller supply, the stock price falls
Taking a long view of the stock market creates less panic and better decisions
In this humble finance bro’s opinion, you should take an assessment of your financial health before loading up on ETFs. I’ll walk you through a financial health checklist in next month’s essay. For now, let’s call it a night.
I’ll see you in October.
Cheers,
Paul
Footnotes
To find out what % of the Company you own, take the (# of shares you have / # of total shares issued)