After my eye doctor appointment today, I ducked into a GAP outlet store and picked up an oxford button-down that I intend to wear and look adorable in. As I hung the shirt up in my closet today, I could NOT stop thinking about investments, and how perfectly I could teach someone about investing just using shopping metaphors.
The most basic concept of investing is NO ARBITRAGE. Arbitrage basically means being able to get something from nothing. With a very simple example, if you have two investments that guarantee 5% and 6% every month and cost exactly the same amount, you could buy the 6% one and short (sell) the 5% one, and pocket that 1% difference yourself without having spent any money. Or alternately, nobody looking to buy one of the two investments will go with the 5% (why make less money when you can make more, guaranteed?). So the relative prices have to change, because what is a price?
A price is whatever someone is willing to pay. (And nobody would be willing to pay the same price for two options that have different guaranteed returns). The price of a stock is what individuals and companies have decided it is 'worth', what they are willing to pay for it. In this way, it's not really clear-cut what's a 'good' stock and what's a 'bad stock' - the same stock has potential to be both at different prices. If you think a stock is worth $50 and its price is now $20, that's good -- if you think it's worth $20 and it's going for $50, well, I would pass. So it's all relative. And even better, it's all related to shopping!
I picked up the shirt for $19.99 (originally $44.99) -- I know, great deal. I could have bought this same shirt at its original price, it would look just as good and be equally soft. Just as many people would check me out (zero, cause I'm the office for all daylight hours, and the shirt might be more comfortable than flattering sorryimnotsorry). I'd get the same enjoyment out of it, so of course the lower price was an additional benefit. If I'd just wanted to blow some money today, I could have found a shirt at Forever 21 for the same price, only maybe it would fall apart after 5 washes. Soo it's a great purchase not because of the cost, but because of the cost combined with the relative value.
Yet, nobody wants to buy stocks when they're on sale (depressed prices). Here's the thing -- people are afraid that maybe this is the time the market won't recover. It will. Possibly not right away, but it will (history is on your side, here). And there will be more recessions and more recoveries, rinse and repeat. Investing smartly is the difference between finding a well-made shirt on sale, or spying an inexpensive crappy one. Buy the former and ignore the latter, invest in companies with strong fundamentals and ignore the inexpensive ones with fail-tastic strategic plans (or no plans at all).
Ahh, but how do you know which company is which? It's not that easy, and we don't all have time for figuring that out. That's why I invest in index funds (broad swaths of stocks or bonds), and know not to pull my money out when the stock market declines. I know, instead, to use that as an opportunity to invest more - a temporary sale is a great opportunity to stock up.