I’d like to take a moment here to talk about applying the “simple ideas” principle, to recent turbulence in the stock market. Dental salespeople work hard for the money. We dedicate an enormous amount of our time to earning money. So, how do we simplify the idea of taking personal responsibility for our investing? Most would be wise to consult a financial advisor. But…. even with that, wouldn’t it be nice to not feel so lost in our own personal analysis of the stock market?
We should all probably be able to have at least some small sense of the market. After all, it’s our hard-earned money at work here! We should be able to form our own personal opinions about where things are, where they might go, and why they might go there. Here are the questions that we probably should be able to answer for ourselves:
1) Where is the stock market priced right now?
2) Where could the stock market go and why?
3) How do I feel about risk, and how am I positioned relative to my feelings about risk?
Let’s first dissect question #1. Is the stock market expensive right now? Is it cheap relative to historical prices? How do I even know how to look at the stock market as a single, whole thing? The best way to see the stock market as a whole, is to look at the S&P 500 index. If one doesn’t know what it is, one can easily look it up. The S&P 500 is an index that includes 500 companies that are so large, that they actually represent nearly 80% of the entire U.S. stock market. We want to see the S&P 500 as a single entity, and then we want to know if it is expensive or cheap relative to history. That can be done.
Imagine if you will, a dental practice called “SP500FamilyDentistry.” Let’s just call this dental practice “SP” for short. If a Dentist were to buy SP, why would the Dentist buy it? The answer is future-cash-flow, or what we might call future earnings. We all know that. The only reason you might have bought a paper route business from some older teenager on your block, back in the neighborhood, was because of future earnings.
Like the dental practice or a paper route, there are ways to evaluate the Price of the S&P 500 index (as a whole) relative to the S&P 500’s earnings. Remember, when you invest in the stock market you are buying businesses. Try to think of those businesses as a simple dental practice or a paper route. There is a way to have a feel for whether or not the stock market is either cheap or expensive. There are actually many ways, but let’s talk about two of them:
–P/E ratio of the S&P 500 index. P/E is a very simple proportion. It is the price of the business, relative to its’ earnings. It is a fraction called “Price over earnings.” It is the exact calculation that the dentist makes subconsciously, when deciding to buy the SP dental practice. It is the exact calculation that the 6th grader makes in 1987, when he’s thinking about buying a paper route from the 9th grader. What is the price of this business relative to the cash I can pull out of it? Click here for this index.
–Shiller P/E ratio. Robert Shiller is a Nobel prize winning economist from Yale. He developed a more conservative S&P 500 P/E ratio that takes into consideration the past 10 years of earnings, so that his indicator would account for market fluctuations and short spikes/valleys. It is often called the “CAPE ratio,” or the “Case-Shiller ratio.” Click here for the Shiller price Index.
Let’s dissect question #2. Where will the market go? Nobody knows! Anyone who ever says that they know is being foolish. The only thing that we can do, is understand that nobody knows. In fact, the more one reads about finance, the more one learns just how much people do NOT know. Does that mean that the stock market is some kind of a fantasy land? No. The stock market is very real, and it involves many businesses that can be bought at varying price levels.
Question #3. The factors involved in this question involve your age, your thoughts on the U.S. economy, your financial needs/dreams, and many others. A financial advisor can be very helpful in helping you to determine your risk profile.
Could Risk and Price be one and the same? I once read a famous book by a wise and famous investor named Howard Marks. It reminded me that the smartest people I’ve ever known buy things at a lower price (think Millionaire Next Door, think Warren Buffett, think of that smart Uncle). I remember taking a piece of paper and writing the words risk and price down, and drawing a circle around them both.
Let’s conclude by pulling out a couple of Simple Ideas to Take Seriously, as it relates to our retirement savings.
Simple Ideas to take Seriously
- We need to take responsibility for our life savings
- We can know the Price of the Stock market
- Maybe Price and Risk are Identical
See You Soon!