Friday, July 25, 2008

How do you think of the stock market?

The first time I heard of the stock market was while reading Gordon Korman's novel Go Jump In The Pool when I was eight years old. The story is about students at a boys' boarding school trying to raise money to install their own swimming pool. The students <SPOILER> finally make it happen when "George Wexford-Smyth III", the token rich boy, uses his stock market wizardry to grow their meager earnings to the $64,469.64 they need for the pool</SPOILER>.

This resolution to the plot confused the heck out of my young mind. Where did all this extra money come from? What's a stock? What does a silver mining company have to do with building an olympic pool?

I asked my parents about this, and they gave me a brief explanation of the stock market: you buy part of a company, and when people get excited about that company, the part you own gets more valuable, so you can sell it for more than you bought it for, and that means you've earned extra money. They also focused pretty heavily on the downside: if people lose confidence in the company you own, you might lose money if you have to sell for less than you paid for it. The message I took from this (reinforced by the fictional headmaster in the book) was that stock market investing is basically gambling, and you shouldn't invest money that you can't afford to lose.

It's amazing how truths you learn as a child can stick with you: this is how I thought of investing all through my university years. While I was in university, cell phones really started to become popular, and Qualcomm was a rising star of the NASDAQ. My roommate at the time was watching this stock with a keen eye, and explained to me the concept of a stock split (Qualcomm split 16:1 between 1994 and 2000). He discussed his plans to invest in the stock, and I asked what he would do if the stock went down after he bought it (in my mind, this scenario meant that you sold your investment at a loss to stop the bleeding).

He countered that he would simply buy more of the stock at the lower price. This concept was completely foreign to me: why would you buy something when it was dropping in value? He explained that when the stock rebounded, he would make an even bigger return on his investment, since he had acquired additional shares so cheaply.

That conversation with my roommate was my first practical exposure to how to buy low and sell high. Granted, he was loading up heavily with a single stock, which was amplifying his risk considerably. While you don't expect every piece of a diversified portfolio to collapse completely, a concentrated position in a single stock can quite conceivably lose most or all of its value in a matter of months or even days. Still, where I had always seen the "buy low, sell high" strategy as a total crapshoot, here was an approach to at least managing the buying side of the plan.

Qualcomm has gone from under $4 to nearly $50 in the last ten years (a 29% annual return). My roommate was right about this stock, and although his strategy was very risky in its lack of diversification, he introduced me to the idea of dollar cost averaging.

I think that an investor's ability to ride out an uncertain market depends on how they see the market. Is it all a house of cards that could come crashing down at any moment, or is it a robust, ever growing system that can be expected to provide consistent positive returns over the long run?

I happen to believe the latter, and I owe it all to Gordon Korman.

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