Trey Lockerbie (02:59):
I feel this book got into the theory almost of why things work the way they do. I highly recommend it. Congrats on the book. I just got to say that much.

Brian Feroldi (03:08):
Thanks so much. That means a lot. Yeah. Like you. I’ve been studying the markets. I’ve been investing for almost 20 years now. I intended the book to be everything that’s extremely simple, the most basic things about the market. But I even learned stuff as I was researching and writing it.

Trey Lockerbie (03:21):
One thing that I want to kick off here with is the power of compounding, because it’s something we hear about a lot. I’m reminded constantly of how our brains are just not equipped to process compounding. It’s just a constant reminder. As much as we understand or think we understand, it’s just elusive to a lot of people especially.

Trey Lockerbie (03:40):
For example, I like to reference the fact that 99% of Warren Buffett’s current net worth was achieved after his 65th birthday, after retirement age. I think that would shock a lot of people. It’s just an illustration of compounding. What might be some other scenarios that our listeners can relate to that would showcase the power of compounding for them?

Brian Feroldi (04:03):
The whole reason I want people to become familiar with what the stock market is and how it work is that so they can harness the market’s awesome power to turn small amounts of money into large amounts of money over long periods of time. One real quick example that showcases that to me just so beautifully is let’s create a fictional person. We’ll call this person Sally.

Brian Feroldi (04:24):
Sally’s career started in 1981. Now, why 1981? That just so happened to be the very first year that the 401(k) was available to America. That was the year that the 401(k) was invented. Let’s say Sally earned a perfectly average salary during that time. Let’s say that she was okay with money. She made money. She avoided debt. But she spent basically every dollar that went into her bank account.

Brian Feroldi (04:51):
However, Sally made one really good financial decision in her life. That is on the first day of her career, she signed up for this brand new thing, the 401(k). Sally didn’t understand what it meant. But she decided to put $400 per month or $100 per week into this 401(k). Now every time she got a letter in the mail saying, “Here’s what it’s worth.” She didn’t understand what it would meant. She took it and threw it away. She never ever looked at it.

Brian Feroldi (05:17):
Well, fast forward the clock 40 years, Sally kept this going up. She never increased her contribution amount at all. In 2020, end of 2020, she decides it’s time to retire. The question is, how much money is in Sally’s 401(k)? I guess I shouldn’t say she invested in the US stock markets this year and the average return during that 40 year career.

Brian Feroldi (05:39):
Well, if you’re good at math, you’ll see that Sally invested a total of $192,000. That was her contribution. But how much was her worth at that point? $3.013 million that was literally 15 times the total amount that she invested. How did she do that? The answer is she harnessed the power of the greatest wealth creation machine of all time, the US stock market. That just shows how important it is to put compound interest on your side.

Brian Feroldi (06:12):
Now during that time, it was a normal couple of decades for the markets. The markets went up about 10% to 11% annualized over that period. There were definitely numerous bear markets during that time. But it just showcases to me how a little bit of money invested consistently into the market can become a huge amount of money. Nothing illustrates the point of that compound interest more than this fact.

Brian Feroldi (06:32):
When she retired at 2020, she had $3 million to her name. If the market kept going up 10% on average, every year that she invested after that point, would create $300,000 in extra wealth, that’s just 10% times the $3 million that she had. That one extra year would create more wealth than all of the contributions that she had over a 40-year period. That’s why getting compound interest on your side is so powerful.

Trey Lockerbie (07:01):
Yeah. I love in the book how you also zoomed out. You mentioned the US stock market and investing in that and this percentage of it going up. Over the course of the year, maybe it’s a little over 60%. But over 20 years, it’s 100% that it goes up on occasion. That brought up a lot of points that you make in the book around indexes and what they are.

Trey Lockerbie (07:23):
For example, I actually remember very clearly the day I was in my car, listening to the radio, and they said something to the effect of the Dow is down two points today. I’m sitting there going, “What does that mean? I have no idea what that means. I don’t know what the Dow is. I don’t know what the points mean. Is that good? Is it bad? Is it terrible? Should I be freaking out?”

Trey Lockerbie (07:44):
I just remember acknowledging how ignorant I was on just the concept of this huge machine that almost runs the world. That felt so silly to me, even though at the time I was a musician, I was thinking, “I’m never going to need to know this stuff.” But it just scared me to some effect is just want to learn about it. For our audience, let’s just start with the Dow. What is it? How did it come to be?

Brian Feroldi (08:08):
Well, Trey, I’ve had the exact same experience that you have. There been several times in my life when the words Dow Jones Industrial Average and points and up and down entered my sphere of knowledge. I was just like, “One, I don’t know what the Dow Jones Industrial Average is. Two, I don’t know what a point is. Three, I don’t know why they’re adding points or subtract the points today.”

Brian Feroldi (08:29):
But I guess more points is good, less points is bad. But once somebody explains what the heck the Dow is and the history of it, it all became crystal clear, at least to me. Rewind the clock to the late 1800s. In the late 1800s, there were publicly traded stocks, just like there are publicly traded stocks today. The way that you got information about the stock market back then was in the newspaper.

Brian Feroldi (08:51):
Now, the head of what would become the Wall Street Journal, his name was Charles Dow. His paper was printing stock prices every single day in the paper. It was just tables with rows of company names and stock numbers and how much they move up or down that day. This table just had a whole bunch of information in it. But there wasn’t a way that Charles Dow could summarize what happened in the stock market that day for his readers.

Brian Feroldi (09:19):
He asked his business partner, his name was Edward Jones, for help. What the two of them surmise is that they would look at the 12 largest and most popular companies at the time. Those were largely industrial companies, so big manufacturers. They took the 12 stock prices that they printed for those companies and they added them up, then they divided that total that they got by 12.

Brian Feroldi (09:43):
Now, what’s it called when you add a bunch of numbers up and then divide by the total numbers? That’s called averaging the numbers. They invented the Dow Jones Industrial Average. Suddenly, by reporting this number to their readers, they could give their readers a sense for what happened in the stock market that day. That was launched in 1896 and it is still referenced today.

Brian Feroldi (10:06):
Now, the Dow has changed over the years to keep up with the changing times. Those 12 original companies that were put in there were eventually replaced and the index in 1928 was upgraded from just 12 stocks to include 30 stocks. If you look at the Dow Jones today, it includes big companies such as Apple, Disney, and Home Depot. But that’s what a stock indices is.

Brian Feroldi (10:28):
It’s when a small group of stocks are used as a proxy for what happened in the entire stock market today. The three most popular stock market indices today are the Dow Jones Industrial Average, the S&P500 and the NASDAQ Composite.

Trey Lockerbie (10:43):
You mentioned the 12 are now 30 companies. How often are the companies being swapped out?

Brian Feroldi (10:49):
There’s a committee that determines which companies go in and which companies go out. The swapping out happens every couple of years or so. I don’t know if it’s on a preset schedule, or I know that they meet annually or biannually and come up with this. It’s not something that happens very frequently. But it happens whenever the committee determines that some company no longer is representative of what the American economy is. They kick that out and they bring in something fresh.

Trey Lockerbie (11:15):
You just mentioned the S&P500, the NASDAQ, and obviously the Dow, walk us through the differences between the three.

Brian Feroldi (11:23):
Let’s start with what is the S&P500. Well, back in 1923, there was a company called Standard Statistics. Standard Statistics saw how popular the Dow Jones Industrial Average had become. Like any good capitalist company, they said, “Hey, well, let’s make our own index to compete with the Dow.” They started out by tracking 233 companies.

Brian Feroldi (11:47):
Now later, Standard Statistics merged with a company called Poor’s Publishing, creating the Standard and Poor’s company. Now in 1957, in an effort to really ramp up their ability to compete with the Dow Jones, they made some changes to the standards index. First off, they expanded it from 233 companies to 500 companies. That was a stark difference between the Dow which only tracks 30 companies and the S&P500, which tracks 500 companies.

Brian Feroldi (12:17):
The logic is by tracking hundreds of companies versus just 30, you get a more accurate information for what’s happening in the market. The second change that they made and was a big difference between them and the Dow was the Dow used the price of a company stock to determine how much it was weighed in the index. The higher the dollar amount of one share, the larger the roll is in the Dow Jones Industrial Average.

Brian Feroldi (12:40):
Now the reason that they did that is because they were calculating everything by hand in the early days, and they knew the stock prices of the numbers. It was a very simple way for them to track and create this index. However, the share price of one share of a company isn’t a good metric for figuring out how big and how important is this company, a better metric for doing that is what’s called market capitalization.

Brian Feroldi (13:02):
Now, market capitalization is the dollar price of one share times the total number of shares that are outstanding. That is the total equity value of that company’s stock. The S&P500 weighed the index according to market capitalization, not the price of one share. Those two changes, the 500, and the market cap weighing really helped the S&P500 to catch on. Now, it’s a more popular index in many ways than Dow Jones Industrial Average.

Trey Lockerbie (13:31):
It actually surprised me about the price weighting of the Dow because that just seems so silly to me, especially in this day and age. I mean, I get what you’re saying about handwriting out the calculations of doings. It’s basically a shorthand of the market. But you’re right. To wait something based on the price of the share is so silly. How is that still even in existence?

Brian Feroldi (13:52):
Yeah. There’s been lots of calls for the Dow to update its data and to do things differently. But one of the big advantages that the Dow has over the S&P500 is it’s been in existence longer than really any other index. At this point, it now has data going back almost 130 years versus the S&P500, which in its current form was created in 1957. That long market history makes the committee, I think, very resistant to changing things.

Brian Feroldi (14:18):
But for that reason, that’s one reason why many professional investors measure themselves against the S&P500, not the Dow.

Trey Lockerbie (14:25):
All right. Let’s talk about the NASDAQ because you brought that up. That’s the third in this trifecta here. Walk us through what the NASDAQ actually is and how it came to be.

Brian Feroldi (14:33):
One of the most popular stock exchanges ever and still to this day is the New York Stock Exchange. That was just a place in Wall Street in Manhattan where investors and businesses got together to buy and sell or exchange shares of stocks. I mean, one simple way to think about that is a stock exchange is like a farmer’s market. You go to a farmer’s market with money, you give that to the food producer, they give you the food.

Brian Feroldi (14:59):
Stock exchange is the exact same thing except for instead of exchanging food for money, you’re exchanging shares or ownership in businesses for money. The New York Stock Exchange is one of the oldest. Today, it’s the largest stock exchange in the world. But the New York Stock Exchange was a … What started out as a physical place where people met up in person to exchange a hand-to-hand, well, that worked well for many years.

Brian Feroldi (15:20):
But in the 1950s and ’60s, computer technology was advancing very, very rapidly. One problem that existed at the time was it was hard to get accurate stock prices to all market participants at the same time. There was a lag with stock prices depending on where you are in the world. Well, computers could be used to solve that problem and make all trading happen at the same time so that prices could be updated everywhere.

Brian Feroldi (15:47):
This group called the National Association of Securities Dealers, the NASD, decided to create their brand new stock exchange in 1971. That was 100% done electronically. This is computers talking to each other. Technology had advanced enough at that point. They launched the stock exchange and called it the National Association of Securities Dealers Automated Quotations, or NASDAQ.

Brian Feroldi (16:12):
Now, this new stock market was very appealing to a lot of technology companies. One, because it was more futuristic, and two, because the NASDAQ was buying technology products from the tech companies. That’s why companies like Intel and Microsoft and Apple chose to list their stocks on the electronic stock exchange, the NASDAQ, instead of the in-person stock exchange, the NYSE.

Brian Feroldi (16:36):
Now as the NASDAQ has grown in popularity, in fact, today, it’s the second largest stock exchange in the world still behind the New York Stock Exchange. But it’s the second biggest in the world. There are now thousands of companies that are listed on the NASDAQ Stock Exchange. When the NASDAQ Stock Exchange was created, just like the Dow and the S&P500, the people that created it wanted an easy way to track what was happening with the prices, broadly speaking of all the stocks that traded on their index.

Brian Feroldi (17:02):
That tool that’s used to track the prices of all those companies that trade in the NASDAQ is called the NASDAQ Composite. That is what’s reported in the paper.

Trey Lockerbie (17:11):
How many companies are in the NASDAQ Composite today?

Brian Feroldi (17:15):
By my estimation, the last time I looked the number was just over 3,000, somewhere around 3,200 companies.

Trey Lockerbie (17:22):
Got it. All right. Going back to that experience of sitting in the car, listening to the radio, hearing about the Dow up two or three points, it brings up this question of why are we measuring by points rather than percentages? I know sometimes you use both. But why is the preference always around points for some reason?

Brian Feroldi (17:40):
As we’re speaking right now, I’m looking at the live view of the Dow Jones Industrial Average. The total value of the Dow is currently 34,564. That’s how many points comprise the Dow Jones Industrial Average current price tag. The Dow, as we speak, is currently up 86 points on the day. It’s really good for newspapers, for headline writers to say things like, “The Dow was up 300 points today,” or “The Dow fell 500 points today” or whatever the number happens to be.

Brian Feroldi (18:11):
That’s a big number that is often entices clicks and viewership. However, the total points that the index goes up and down really doesn’t matter all that much. What’s far more relevant is the percentage gain in the index on any given day. Again, right now, today, the index is up 88 points as I’m reading this. But on a percentage basis, the index is only up 0.25% today.

Brian Feroldi (18:36):
If you were a headline writer, what would sound more interesting, the Dow was up 80 points today or the Dow was up 0.25% today? At least, newspapers still largely reference the indexes in terms of points. But points are like facts. It’s really percentages that provide the context that investors need.

Trey Lockerbie (18:56):
When we talk about points, we’re not talking about basis points of percentages, because I think a lot of people could confuse that. We’re actually talking about a composite of points that make up the index and how much that has increased or decreased. Is that correct?

Brian Feroldi (19:09):
That is correct. The NASDAQ is currently up literally 86 points on the day meaning yesterday it was 34,490. Currently, it’s 34,570. It’s up 80 plus points on the day.

Trey Lockerbie (19:25):
When the stock market does go up like that, or it goes down, we either call it a bull market, or a bear market. This was a fun history lesson in the book that I was also pleased and surprised by, because these are just terms you accept and acknowledge for no reason off the top is just what everyone says. You go, “Yeah. Yeah. I know it’s a bull market.” Why do we call it a bull market and why do we call it a bear market?

Brian Feroldi (19:47):
Like everything, it’s a nickname that was given to different types of markets. But broadly speaking, a bull market is when prices are rising and are expected to continue rising. Now why is it called a bull market? Well, if you can picture the head of a bull with horns, a bull attacks by thrusting its horns upward. That’s the direction that the bull attacks and, hence, why it’s called a bull market.

Brian Feroldi (20:12):
Conversely, a bear market is when market prices have fallen by 20%, or more from a recent high. That’s because the way that a bear attacks is by swiping its paw downwards at its prey. Who came up with those terms? I don’t know. But like you said, they’ve become common ways for us to describe whether market prices are rising, a bull market; or falling, a bear market.

Trey Lockerbie (20:36):
I love it. All right. Now, I want to get into why companies go public in the first place. One major point, I think, if you surveyed a hundred people, I think, most people would actually get this first point wrong, which is, if I buy a stock today, does the company get that money? If for example, I would estimate that a lot of people who in just the last year, opened up a Robin Hood and bought some Tesla, for example, think that that $100 is going towards a new battery, or a new whatever. Now, walk us through why that is not the case.

Brian Feroldi (21:09):
There are numerous reasons why companies go public. But typically, the number one reason that companies go public or choose to list on a public exchange is because they need to raise capital. There are several ways that companies go from being private to being public. But one of the most common ways that companies do so is through an Initial Public Offering or an IPO.

Brian Feroldi (21:30):
This is when a company that is privately held, creates brand new shares of stock and takes that stock and sells it to the public by listing its stock on a public stock market exchange, such as the New York Stock Exchange or the NASDAQ. Once that happens on the very first day of trading, investors pay buy those shares from the company. The company gives those shares to the investors. If you buy at the IPO, you are literally giving your money to the company.

Brian Feroldi (21:59):
However, once the company gives those shares and sells them for the very first time to investors, those shares no longer belong to the company. All the prices that we see going up and down every day on the various stock markets are one investor selling their shares in their stock to another investor. If you go on the stock market and want to become an investor in Tesla, and like you said, put say, $100 into Tesla today, you go and you place … buy order that your broker takes your money and finds another investor that’s willing to sell their Tesla stock to you, and that’s when the exchange happens.

Brian Feroldi (22:34):
Tesla, the company is in no way involved in that transaction. They do not get the money when you buy a stock. Only the other investor on the other side of the transaction does.

Trey Lockerbie (22:44):
All right. Let’s dig into Why the Stock Market Goes Up, which is the title of the book. Let’s get into all the nitty-gritty around earnings and how they grow and how the price is affected by that, et cetera. Walk us through why the stock market goes up and why it tends to go up consistently over time?

Brian Feroldi (23:04):
Let’s back up and just answer the question, what is a stock? A stock literally represents fractional ownership of a corporation. Stocks were invented because they vastly simplified the record keeping for who owns how much of a given company. When we look at the S&P500, for example, that means that there are 500 publicly traded companies on the US stock market.

Brian Feroldi (23:31):
By adding up the share price of all those companies, when you go to buy them, you literally become an infinitesimally small owner of all 500 of those companies. Why does the stock market in the S&P500? Why is it risen over time and why should it continue to rise, hopefully for the rest of our lives and many years beyond that? Well, when you become an owner, a shareholder of a company, you now have a legal claim on that company’s assets, what it owns, and that company’s current and future profits.

Brian Feroldi (24:06):
As a company generates profits, those profits don’t belong to the company. They belong to the owners of that company, which are the shareholders. By enlarge, if you look at over a long period of time, the earnings or the profits of all of the companies in the S&P500 tend to rise over long periods of time. Now, there are many underlying factors that cause those profits to rise, including population growth, inflation, innovation, stock buybacks, productivity, things like that.

Brian Feroldi (24:39):
But broadly speaking over long periods of time, the companies in the S&P500 tend to become more and more profitable each year. You as a shareholder of those 500 companies have a legal claim on a never ending stream of growing profitability. For that reason, the value of the S&P500 tends to go up when measured over long periods of time. Although, as I know that you know, over short periods of time, the stock market can visit some very interesting places.

Trey Lockerbie (25:09):
Well, and this point specifically ties back to the power of compounding. There’s this great Benjamin Franklin quote in your book that I had … I don’t think I’ve read before, but I love it. It says, “Money makes money. The money that money makes, makes money.” Give an example say the better coffee company which you have in the book or Starbucks opening up shop next door, how opening up more and more doors, then the intention of raising that money goes towards the expansion and then therefore, the compounding of earnings?

Brian Feroldi (25:38):
Yeah. A real simple example I think everyone can relate to is Starbucks. Everyone here that’s listening is familiar with Starbucks. As I look at Starbucks valuation today, Starbucks is currently worth $100 billion dollars. That is the total equity value of Starbucks’ common stocks. Starbucks is a gargantuanly huge company. However, when Starbucks came public, nearly three decades ago, it was a far, far smaller company than it was today.

Brian Feroldi (26:09):
At the time, the company only operated a few hundred stores largely around the West Coast of the United States. Now, one reason that Starbucks went public, because it wanted capital, it needed capital, so that it could open more stores. Why did it want to open more stores? So that its revenue, and its profits would continue to grow, and the value of Starbucks would continue to grow.

Brian Feroldi (26:34):
This is one very easy way that investors can visualize how companies can take capital, reinvest it in themselves, and grow over time. I don’t know the numbers exactly. But let’s just say at Starbucks and initial public offering, it had 200 total stores outstanding. There’s 200 Starbucks in the world. We’ll fast forward today, and there’s about 17,000 Starbucks in the world.

Brian Feroldi (26:58):
The total number of Starbucks that exists around the globe has gone up almost 100 fold over its lifetime. Well, with literally 100X more stores available today than they were 30 years ago, what do you think has happened to Starbucks revenue? What do you think has happened to Starbucks profits that time? It’s up tremendously.

Brian Feroldi (27:17):
The reason that Starbucks was able to do that is because it raised capital from investors, it took that capital, it built new stores, those stores generated profits, those profits were reinvested to open up even more stores the next year, and that process has happened over and over and over again. That’s how Starbucks started as just a very small coffee chain in the northwest of the United States.

Brian Feroldi (27:40):
Now is a global phenomenon with tens of thousands of stores. During that time, as it was expanding and its revenue was growing, and its profits were going, the total value of Starbucks has grown in lockstep with that. Now, not in perfect lockstep. There were times when Starbucks stock price and equity value was growing very quickly, faster than historic account. There are other times when Starbucks stock price is falling, even though the total number of Starbucks was going up.

Brian Feroldi (28:06):
But over long periods of time, the reason that Starbucks is worth $100 billion today is because the company’s revenue and profits are many, many, many times bigger today than they were when Starbucks first got started.

Trey Lockerbie (28:20):
Another reason that the stock market goes up that you touched on a little bit earlier is innovation. This one is, again, easy to understand in theory. But you’ve laid out this great example that I just want to highlight, which is basically the fact that in 1990, not a single person owned a smartphone. As of 2020, you had 3 billion people have a smartphone with over $700 billion of revenue coming from this brand new innovation.

Trey Lockerbie (28:46):
What are some other innovations that you’re seeing today that could emulate something like the smartphone that will advance the stock market forward in the future?

Brian Feroldi (28:55):
I truly believe that right now, we are going through the most innovative and most disruptive periods in human history. It’s hard for me to wrap my head around what the world could possibly look like just 10 years from now with the number of innovations that are out there. Now, there are literally dozens of innovations, innovative technologies that are currently emerging and promised to change things.

Brian Feroldi (29:18):
Like any innovation, not all of them will matter. Some of them will flame out and some of them won’t matter at all. However, it’s possible that even just one or two of these could become as important to humanity and impactful as the internet is. Think about all of the businesses that exist today because the internet came to be 40 years ago.

Brian Feroldi (29:38):
Here’s a couple that I’m currently looking at and I think are very exciting, 3D printing, artificial intelligence, autonomous vehicles, blockchain technology, cloud computing, carbon sequestration. CRISPR, cryptocurrencies, cybersecurity, DNA computing, desalinization technology, edge computing, electric bikes, electronic payments, electronic vehicles, geothermal heating and cooling, holograms, the Hyperloop, the internet of things, nanotechnology, online dating, personalized learning, personalized medicine, personalized ensuring, plant-based meat, plastics 2.0, precision biology, robotic surgery, et cetera, et cetera, et cetera.

Brian Feroldi (30:21):
I mean, there are literally dozens of innovative categories that are happening right now. While many of these categories were likely to flame out and become nothing, just a few of them could really be so impactful on humanity that it profoundly changes our economic system.

Trey Lockerbie (30:36):
Not to single out ARK, but I’m going to single out ARK here, because ARK’s thesis is investing in innovative technologies, pretty specifically. They’ve gotten a lot of heat over the last year because they shot up in value, I mean, their ETF, shot up in value and has since gone down something over, I think, 50%. That begs the question, why does the stock market sometimes go down? We covered why it went up? What is the inverse of that?

Brian Feroldi (31:01):
You have to think of the stock market as a live continuous auction that’s happening at any period of time. When you look at just how any given company is valued at any given point, there’s really two factors that matter that determine the valuation or the price of that company at any given time. One is the underlying profitability of that company and how those profits are expected to change into the future.

Brian Feroldi (31:28):
Companies are typically valued. One simple way to value companies is on a multiple of their profits. A very simple metric for tracking that is called the price to earnings ratio, or sometimes called the P/E ratio. All of the things held equal. Let’s say a company is doing $1 in profits in earnings per share, and investors value that company at 20 times profits, that stock is trading at $20, 20 times a dollar in earnings per share.

Brian Feroldi (31:54):
You can see with that $20 valuation, only $1 of that current valuation is the current earnings power of that company. The remaining $19 is the amount that investors are willing to pay for the future profits of those company. Well, humans are emotional creatures. When we see something bad happening in the world, or we become fearful, or less certain about that company’s profits showing up, one reaction that people have is to sell their stock in anticipation of a decline in earnings.

Brian Feroldi (32:24):
Now, historically, when you look at the big bear markets that are happening, the big times and stocks have gone down, they’re typically associated with some major bad macro event. That could be the Great Depression of 1929, could be World War Two. It could be a political event like Watergate, or an assassination. It could be the back downside of excess speculation such as when the dot-com crash happened.

Brian Feroldi (32:47):
It could be financial crisis, which has happened several times in the US, or it could be a global pandemic, like we saw in 2020. But there’s usually some kind of bad macro thing going on that causes prices, investors to become fearful. As investors become fearful, they have race for the exits and they rush to sell their stock. That initially causes stock prices to fall, which in turn creates even more fear amongst more other investors and stock prices fall again.

Brian Feroldi (33:14):
That process cycles on itself again and again and again. That’s why stock prices can sometimes dramatically decline. When that happens, it’s called a bear market.

Trey Lockerbie (33:24):
I love that you highlight the P/E ratio there, because it’s something that is so commonplace when it comes to valuation. Obviously, there’s lots of ways to value a company. But this is the most shorthand, quick snapshot of evaluation of a company that most people adopt. Last time you were on our show, you brought this really great point that you should maybe not focus on the P/E, especially if there’s a high growth company at hand, meaning when a company is in high growth mode, earnings is not necessarily the priority.

Trey Lockerbie (33:56):
You have to project out what those earnings are going to be in the future, and then determine what the price multiple will be on that. Just to highlighting that fact, for most people who are getting into investing, and I recently interviewed Michael Mauboussin on the show, and he likes to tell his students at Columbia that you have to earn your multiple. You have to tell him why you’re even using a multiple in the first place.

Trey Lockerbie (34:17):
I’m just highlighting for people that while this is so commonplace in shorthand, it is nuanced, and there is a lot more context involved. But one piece of the P/E ratio that we haven’t covered that I want people to understand is that if you inverse it, you are actually getting a yield that you’re expecting from that. Walk us through how that works.

Brian Feroldi (34:36):
Let’s go back to our very quick example that we had before a company is doing $1 in earnings per share, that company had a 20 P/E ratio on it at the time. That gives us a stock price of $20 per share. However, if we take that P/E ratio of 20 and we invert it, we can also get the earnings yield that we get as an investor from buying that company.

Brian Feroldi (35:00):
Let’s say I go out and I want to buy that stock, I pay $20, I get the stock, and I now have a claim on $1 in earnings per share. What is my earnings yield on that? Well, the answer is the inverse of 20, or a 5% yield on my investment. That can be a helpful numbers that investors can use in their head, because it allows you to compare the earnings yield on, say, a company or an index and compare it to something like bonds or CDs and the interest rates on other various things.

Brian Feroldi (35:32):
Like anything as you just said, the P/E ratio and the P/E yield are tools that investors can use to value companies. However, there’s shortcomings to every tool, and there are multiple ways to do it, and everything involved with investing. Absolutely, everything has tons of nuance to it.

Trey Lockerbie (35:49):
Now, as you bring up the earnings yield, it’s reminding me of the dividend yield as well. I remember again, going back when I first started learning about investing, hearing about dividend yield for the first time, and it just not computing in my brain, even though it is actually a very simple equation and easy to understand. Just while we’re on it, let’s talk about why dividends are important, and what a dividend yield is really telling us.

Brian Feroldi (36:14):
Sure. What is a dividend? A dividend is when a company takes a portion of its profits and gives those profits directly to their shareholders. That’s what a dividend is. Let’s go back to our really simple example there. Our company did $1 in earnings per share for the yield. Let’s say that that company had no use for that capital. It decided to take that $1 in earnings per share and give it directly to its shareholders.

Brian Feroldi (36:42):
In this case, the company had a 100% payout ratio. In other words, this company is giving 100% of its profits back to its investors in the form of a dividend. Well, what would be the dividend yield on this company? Well, again, it would just be that $1 in earnings per share, divided by the $20 share price. That would be a 5% yield on our purchase at $20.

Brian Feroldi (37:07):
Now, I can tell you that, like you seem to be, when I first learned of dividends and dividend yields, I was like, “Well, this is like magic. It’s free money. But shouldn’t I go out and try and find the highest dividend yielding companies that I could find?” When I came to that amazing discovery, I quickly use some screening tools and found companies that were paying 10% yields, 15% yields, 20% yields.

Brian Feroldi (37:30):
I was like, “Great. I just got to buy this company, hold it, and I earned a 20% return on my investment.” That sounds great to me. Well, as you can probably guess, if it seems too good to be true, it probably is. The reason that many companies that are out there have very, very large dividend yields is because dividend payments are not guaranteed. If a company isn’t earning that profit, it might not be able to make those dividend payments.

Brian Feroldi (37:56):
Typically, if you see a yield, a dividend yield that’s very high, that’s because a company that was formerly paying a dividend, their stock price has fallen dramatically. Why would their stock price fall dramatically? Because the underlying profitability of the business is in question.

Brian Feroldi (38:12):
When I first started out, and I was buying these companies that had yields of 20%, I quickly learned that they had to stop paying their dividends because the business was falling apart. That caused me to not only lose out on those dividend payments, but the stock that I bought continued to fall dramatically. I learned the hard way that if a dividend yield seems too good to be true, it probably is.

Trey Lockerbie (38:34):
Yeah. I would add another indicator to that, which is to see if the company is going into more and more debt just to keep up with that dividend that they promised investors. Could you do actually see that as well? All right. Let’s talk a little bit about timing the market. Now there’s that old saying it’s not timing the market, it’s time in the market and how timing the market is a fool’s errand.

Trey Lockerbie (38:58):
Right now, you’re seeing in the markets a lot of volatility, a lot of people are projecting economy will be either good or bad, inflation rising or falling, et cetera. Should we, as investors, stop investing if the economy is bad?

Brian Feroldi (39:15):
It’s very tempting to look at what’s happening in the world. If you see negative headlines, a very natural feeling is to say, “I can’t invest right now. It’s too risky to do so. I mean, look what’s happening today. We have inflation. We have a war that’s going on. The pandemic is still out there. It is a scary time economically to be investing.”

Brian Feroldi (39:37):
But one investor that I really liked a lot named, Ben Carlson, he created this great chart in one of his books that he wrote that just blew me away when he read it. He did a quick study and he found out what are the annualized returns of the S&P500 at various periods of unemployment in the US. Unemployment, the higher the number, the more people are looking for jobs.

Brian Feroldi (39:58):
Well, what his analysis found what was that when the unemployment rate in the US is under 5%, the annualized return of the S&P500 is 3.9%, 3.9%. When economic times are really, really good, unemployment rate is very, very low, the S&P500 returns about 3.9% per year. Conversely, when the unemployment rate is over 9%, horrific, so many people are out of looking for jobs. The annualized return of S&P500 is 24.5%.

Brian Feroldi (40:32):
Literally six times higher return from if you invest during periods of high unemployment than low unemployment. Now, how could that be? Why on earth when investing when the economy is in terrible shape do better than when the economy is in great shape? Well, typically, when the unemployment rate is low, the economy is doing very, very well.

Brian Feroldi (40:53):
When the economy is doing well, investors are in a good mood, and investors tend to pay higher and higher prices for stocks when they’re in a good mood. That lowers that earnings yield that we talked about before. That means that future returns are going to be lower. It makes complete sense to me why the returns of the S&P500 are low when economic times are good. Take that and flip it around on its head when times are bad.

Brian Feroldi (41:17):
When the unemployment rate is very high plus 9%, that’s typically because there’s something really, really bad that’s already happened in the economy. When there’s something really, really bad going on, stock prices typically are down hugely from their high. The earnings yield is higher and investor sentiment is very, very low.

Brian Feroldi (41:35):
While it can be very tempting to look at what’s happening in the newspaper and said, “I can’t invest now, it’s too risky,” more often than not, when you feel that way, that’s actually the best time to put capital to work.

Trey Lockerbie (41:47):
Yeah. I was going to say is that because if unemployment is high, and the companies don’t have that payroll expense, their further earnings are higher? I mean, that was what I was going to, but it doesn’t sound that’s quite correlated. Something that is seemingly less risky is something that I would think people understand a lot less even in stocks, and that would be bonds.

Trey Lockerbie (42:06):
We’ve talked a lot about stocks. I’d like to quickly touch on what a bond is, and especially how they are priced, because this can be a little bit elusive to most?

Brian Feroldi (42:16):
Everybody is familiar with a bond, especially if you’ve ever bought a house. Let’s say you want to buy a house that costs $500,000, but you only have $100,000. What do you do? Everyone knows the answer to that question. You go to a bank and you get a mortgage. You borrow the $400,000, you make the purchase. In exchange, you agree to pay back that loan over some period of time. In the US the most common time period to do so is 30 years.

Brian Feroldi (42:44):
Well, companies and governments can do that exact same thing. When they need capital, and they want to raise it and get a mortgage, we call that a bond. A bond is simply an IOU that an investor loans a company or government money, and the investor is promised to get their money back at some future date. Now, we don’t loan money to people and not expect anything in return.

Brian Feroldi (43:08):
The charge or the cost of that bond is called the interest rate. That is just the percentage that the borrower has to pay above and beyond the value of the bond in order to access that money. That’s all a bond is. A bond is a debt instrument that an investor makes to a company or to a government.

Trey Lockerbie (43:27):
Last time you were on our show, I believe we talked a little bit about when to sell a stock. I think you even have a checklist for this as well, because you love your checklists. I think it’s a great tool as well. But I often see with my friends who are investing in stock market for the first time, they see this when, this little pop in value and they go, “Oh, my gosh, my stock just shot up 10%. Should I sell it?” That’s the question I get more often than not.

Trey Lockerbie (43:50):
Talk to us a little bit about what happens when your stock actually performs well, and how and when you should consider actually selling it?

Brian Feroldi (43:56):
One of the natural things that happens to me when I first started investing is let’s say I bought a couple of stocks and one of them went up a lot, another one went down a lot. My natural inclination would be to sell the one that was going up and buy more of the one that’s going down. Well, Peter Lynch has a great quote on that. He basically calls that the equivalent of watering your weeds and cutting your flowers.

Brian Feroldi (44:22):
So many things about investing are counterintuitive. They are literally the exact opposite of what’s your natural instinct is to do. If a company’s stock is going up, there’s lots of reasons that that could happen. But by and large, the most common reason that happens is because the company that is behind that stock is succeeding. They’re doing something right. They’re executing their game plan, perhaps they launched a new product or the product is gaining popularity, and the market is rewarding that company for doing well.

Brian Feroldi (44:52):
Conversely, you can say that a stock is falling, especially when compared to the market in general for exactly the opposite reason. Maybe they’re failing to live up to expectations. Maybe their new product isn’t getting traction in the marketplace. Maybe the company is having trouble with execution.

Brian Feroldi (45:07):
When I first started investing, my natural inclination was to buy more of my losers and sell my winners early. In fact, I now do the exact opposite. My stock I own, if the business isn’t doing well, and that stock is falling, I don’t buy more of that stock. If a stock is going up, that actually excites me as an investor. That would be the one all things held equal, I would rather put capital in.

Trey Lockerbie (45:31):
What you’re touching on there is dollar cost averaging, which you do lay out here in the book. I find this to be so fascinating, because I do think this is a folly for most novice investors, which is, “Oh, it went down. Let me buy more. I’ll dollar cost average my price down.” That makes all kinds of sense. In fact, it ties back to a Warren Buffett value investing approach, because price is what dictates everything with that style of investing.

Trey Lockerbie (45:59):
Obviously, at a lower price, it’s a better deal. But what data, if any, have you seen around the idea of actually cutting losses and adding to winners over time? Is there empirical evidence that that is actually a better strategy? Or is that just your experience from what you’ve seen it with your own performance?

Brian Feroldi (46:17):
One of my favorite market studies that was ever done was conducted by JP Morgan many, many years ago. They looked at the prices of thousands of publicly traded stocks over a 30-year period. What that study concluded was about 40% of stocks that are on the public markets will fall 70% or more and stay down permanently. They put their investors through a huge economic loss.

Brian Feroldi (46:42):
About 25% of companies will underperform the market over time, but won’t do that bad. They’ll just be trailed behind the market. Another 30% or so of companies will actually do better than the market in general, but just barely. About 7% to 10% of companies, depending on the industry that you’re in, those stocks will go up so much that they literally cover all of the losses of the other companies and drive the entire market higher.

Brian Feroldi (47:10):
Now, what are those companies stocks have in common? What are those mega winners have in common? Well, their stocks were already up huge, and they continued to win. What are those stocks that lost in the market badly have in common? Their stocks went down and then continued to go down. Again, this is such a counterintuitive lesson that I had to learn the hard way. That lesson is winners tend to keep on winning, and losers tend to keep on losing.

Brian Feroldi (47:37):
Is there exceptions? Of course, this is investing. There’s always exceptions to every rule. But broadly speaking, if you showed me 10 companies that stocks were going up, 10 company stocks are going down and said, “Pick your horse.” I would pick the ones that were already going up.

Trey Lockerbie (47:50):
Okay. One of the reasons I think people should buy this book is … especially if you’re just starting out, is not only for all the basic material that we just covered and if you’re just getting started investing. But at the end of the book, you do go into a lot of actionable items, meaning things such as where do I buy stocks? How do I set up an account? Which account should I set up, et cetera, et cetera?

Trey Lockerbie (48:12):
It’s very actionable, very helpful. We aren’t going to get into that today. But one thing that stood out to me was, again, one of those things that has been around forever in my mind, and I’ve just never questioned, which was the 401(k). You mentioned earlier in this interview that the 401(k) came about almost as like a mistake, I believe, or some circumstantial thing and now it’s around and continues to be around. Walk us through the story behind the 401(k) and how it came to be.

Brian Feroldi (48:40):
Quick little side story. When I was in, I think, middle school, I had to interview my dad about what he did in his benefits and all that stuff. As I was doing that, he said, “Well, I have a 401(k).” In my mind, I was like, “Does that mean you make $401,000 per year, is that your salary?” Because it’s such a weird thing to call it a 401(k). But if you look at the history of the 401(k), you understand why it was labeled that.

Brian Feroldi (49:06):
What I love about the story of the creation of it, it was an accident that the 401(k) was created. In 1978, Congress made some big changes to the US tax code and those changes went into effect a few years later. Now, an eagle-eyed benefits attorney named Ted Benna was reading through the changes and looked at Section 401(k) of the changes.

Brian Feroldi (49:29):
He noted that employees could now, because of the tax changes, defer taxes on income that was invested in the stock market. That seems like a very small change that Congress just overlooked when it threw in there. But what Benna realized and surmise is that the language was vague enough that it could be applied to thrift saving plans.

Brian Feroldi (49:50):
Now, because of tax code change 401(k), you could combine the pretax profit sharing plans, the benefits of the pretax profit sharing plan with the employer match of a thrift plan. Benna actually went to his own company and convinced them to launch essentially the world’s first 401(k). It gradually caught on. Today, it’s the number one way that Americans save for retirement.

Brian Feroldi (50:18):
As of June of last year, there were $7.3 trillion in 401(k) accounts. But it’s all thanks to this benefits attorney that noticed that the language was vague enough and convinced his own employer to set one up.

Trey Lockerbie (50:32):
If you’re one of those listeners out there that is sitting back and made it through this far and says, “You know what? None of this applies to me because I have a 401(k) at my work, and I don’t have to think about any of this.” Then I would say, “Well, why are you listening to the show?” But also, you should be advised on this mistake that I wasn’t aware of, but you bring it up in the book around 401(k)s and how often a lot of people think their money is being invested in a 401(k), when in fact, it’s not. What is going on there?

Brian Feroldi (51:00):
Yeah. If you talk to somebody that isn’t very fluent in finance, they’ve heard terms like 401(k), IRA, and Roth et cetera. They think that that is an investment choice that you can make. They say things like, “Oh, I have a Roth,” or “Oh, I have an IRA.” As if buying this thing called Roth automatically makes you invested in the market. In truth, 401(k)s, Roth, IRAs, those are all just wrappers around an account that provide that account with some specialized tax treatment.

Brian Feroldi (51:28):
One big mistake that could potentially be a multimillion dollar mistake is they sign up for an IRA or a 401(k), they fund the account with money, but they don’t take the next step, which is actually investing that money into the stock market. Now, some accounts make that process very simply, and even do that for you automatically. But just because you set up an IRA or Roth doesn’t mean that you’re invested in the market.

Brian Feroldi (51:53):
If you’re going to do that, please double check to make sure that the money is invested and not just sitting there in a cash account.

Trey Lockerbie (52:00):
All right. Brian, well, this is a lot of fun. The book is called Why Does the Stock Market Go Up? I love not only that this book was written, but that you wrote this book, because you have this amazing ability to break things down to the absolute brass tacks, so to speak, of what the topic is at hand. It’s a very easy read. I recommend it to everybody, even if you’re an experienced investor.

Trey Lockerbie (52:21):
Before I let you go tell people where they can find you, where they can find the book, any other resources you want to share.

Brian Feroldi (52:28):
The book is officially launched on April 5th, and it’s available at all the major places, especially Amazon. But if you want to connect with me, personally, I’m most active on Twitter, and that’s @BrianFeroldi. I also have a YouTube channel. That’s my name. But I’m on all the social platforms under my name.

Trey Lockerbie (52:45):
Congratulations, Brian. Thanks a lot for coming back on the show. It’s always a pleasure.

Brian Feroldi (52:49):
Trey, it was awesome to be here. Thank you so much for having me.

Trey Lockerbie (52:52):
All right, everybody. That’s all we had for you this week. If you’re loving the show, be sure to follow us on your favorite podcast app. Be sure to come visit us in Omaha at the Berkshire Hathaway meeting. Get in touch with me on Twitter @TreyLockerbie. That’s where Brian and I originally met. Absolutely do not miss out on all the resources we have for you at the investorspodcast.com. With that, we’ll see you again next time.

Outro (53:14):
Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by The Investor’s Podcast Network, and learn how to achieve financial independence. To access our show notes, transcripts, or courses go to the investorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.