As kids, we learned that our temperature was supposed to be around 98.6 degrees. If that number was off, we knew we were sick. In school, our test scores were important. If they fell off, we knew we were in trouble. And as we grew older, the important numbers have varied: some days it’s our salary, some days it’s our blood pressure that matter. But there are always numbers that we’re keeping an eye on.

Over the last few months, some new numbers have joined the list of the closely watched, and those are the various indices of Wall Street as the stock market lurches up and down. The market takes a dive and people are convinced the world is about to fall apart. Then the market suddenly shoots up — and this is equally unnerving. What’s going on?
The reality is that the market going up or down shouldn’t impact the lives of most people. Unless you brought stocks on margin or you’re making your living as a trader or you’re about to withdraw a large amount of money, your life should be unaffected by where exactly the market closes today. The effects, however, appear when emotional reactions to the market numbers start to affect real-world decisions about jobs, purchases and policies.

Let’s look at a few basics points about the stock market.

The market is based on emotions, not logic: Almost all changes in the stock market are based on public perception, not on company performance.  A company will announce its quarterly earnings and its stock will go up or down based on public expectations about that number. If earnings are more than had been anticipated, the stock will go up dramatically. On the other hand, if earnings are less than had been predicted, even by a tiny amount, the stock will plummet.

When Congress approved a bail-out of the financial sector, people expected this to help resolve the economic crisis and so the stock market went up. Two days later the public decided that the bail-out wasn’t going to help as much as had been hoped, and the stock market dropped by many hundreds of points. Nothing in the companies that make up the Dow-Jones had changed over those two days. All that changed was the perception of what the future would look like.

Long term vs. short term: The real value of investing in the stock market lies in the long run. If you buy shares in any ten companies that are part of the Dow-Jones, leave them untouched for 10 years and reinvest the dividends, you will make a lot of money. For example, if you had invested $10,000 in each of five companies — General Electric, Wall Mart, Home Depot, Bank of America, and Coca Cola — on October 24, 1996, your $50,000  investment would be worth $171.683.24 on October 24, 2008. That’s a 243.4% return on your investment, even though the Dow is about the same now as it was in 1996. The fact is, if you diversify your money among several large companies and you reinvest your dividends, you will make money in the long run even if the market crashes a few times over the years.

The reason people lose money in the stock market is that they buy on impulse and they sell on impulse, which means that they inevitably buy high and sell low.

Don’t rely on experts: It’s amazing to see that even the biggest experts on Wall Street don’t follow the basic discipline of investing for the long run. One of the few exceptions is Warren Buffet, and you can see where it’s gotten him! He buys shares in companies he understands and he keeps them for many years. This sounds very simple and it is, but it takes discipline. Most experts don’t have this discipline so if we listen to them, we end up losing money.

Looked at objectively, most major companies are still doing okay and they will do even better in the future, with a probable exception being companies in the financial sector.  So if you have some extra cash and are willing to invest for the long run, now is the perfect time to buy into some terrific companies because you can get them at bargain prices.
And remember that the stock market numbers really aren’t that important to most of us, so sit back and relax.

QUOTE OF THE WEEK
When asked what the stock market would do, J.P Morgan replied: “It will fluctuate.”

© 2008 – 2011, Keren Peters-Atkinson. All rights reserved.