Everything You Should Have Been Taught About Investing in School, But Weren’t


Clint Murphy Brian Feroldi


Clint Murphy, Brian Feroldi

Clint Murphy  00:00

Brian, welcome to the growth guide Podcast. I’m excited to dive into your book with you today Why the Stock Market Goes Up and to give people a primer on investing. Before we get into that fun, can you give the listeners a brief bio and background on you? And then we’ll take a dive into the book.

Brian Feroldi  00:21

Sure, I’m Brian Feroldi, I consider myself to be a financial educator. And when I graduated from college in 2004, I knew absolutely nothing about the stock market, about investing, it was all foreign to me. And the crazy thing is, I say that as someone that graduated with a degree in business, so despite studying business in college, I was still completely illiterate, with what the stock market was, how it works, etc. In 2004, after I graduated, my dad handed me a copy of a gateway drug book that I call it: Rich Dad, Poor Dad by Robert Kiyosaki, I devoured it in a couple of days. And that just set off a never ending a thirst for knowledge about everything related to money, personal finance, and investing. So I read as many books as I could about to investing as I could, I decided that the stock market was the investment vehicle that I was most attracted to. So I read all the classic books by buying about Peter Lynch, Warren Buffett, Charlie Munger, Seth Klarman, etc. So I understood what the stock market was and how it works. But one question that always perplexed me was why the stock market went up over time, then I never understood why that was, I read lots of books that said things like the stock market always recovers from downturns. It always goes up about 10% per year. But I never understood what actually caused that to happen. So two years ago, I decided that I guess that I was waiting for a book to be written that explained that in plain English, but no such book existed. So two years ago, I decided to write the book.

Clint Murphy  01:57

Excellent. And it definitely, for a beginner, by the time you get to the end of the book, you’re going to understand what are the drivers. Why does it take individual businesses all the way to an aggregate of businesses, all the way to really an aggregate of our belief in humanity and growth and productivity over time. So we’ll take people through all of that. So when they leave the conversation, they’ll say, Hey, I understand why the stock market moves up and to the right over the long term. So starting with that, one of the one of the lines that you use a few times in the book, and a lot of people say this, whether it’s Rich Dad, Poor Dad, or on financial Twitter, is that the stock market is the greatest wealth creation machine of all time. What do you mean by that? And why should the listeners ears perk up when they hear that?

Brian Feroldi  02:53

Yeah, this is something that again, people people say without truly understanding what it’s mean, if you look at the long term history of the United States stock market, which is broadly defined as the s&p 500, the stock market, United States has returned an annualized return of about 10% per year, for the last 130 plus years. And that 10% per year is an incredibly powerful number, because that that can turn a small bit of money dripped in slowly into millions of dollars in the average person’s working career. In the book, I give a simple example of a typical worker starting their career in 1982. And  they contribute some money to their 401k each year, and then they continually invest in just a broad based index fund for the period of 40 years. And doing so literally turns a $400 per month investment, starting in 1982, into more than $3 million. By the time they leave their working career 40 years later. So $400 per month turns into more than $3 million, thanks to the power of the United States stock market. Now that is one of the highest returns that you can get of any asset class out there. Stocks beat bonds, they beat cash, and they beat the returns of real estate. The reason that people really make a lot of money with real estate or really like real estate, is that real estate comes with leverage, meaning you can buy real estate by using debt with juices the returns that you can get, but from my money, nothing beats investing in the United States stock market over the long term.

Clint Murphy  04:38

The And what I love about the stock market is you can set it and forget it. And I think that’s where people will be really successful when they do it. For the average listener, you hear the idea of stock market and if you don’t really understand well, what is that comprised of? So if we look at Stock market, we break it down. Well, it’s, it’s made up of the stock of a number of corporations. So two things, if we can educate the listeners a little on what is the stock and what is the corporation, and why do our companies or people want to set up a corporation and then issue stock? What are those two components and how do they comprise overall the stock market?

Brian Feroldi  05:31

Yep, excellent point. I love breaking down the basics, right? So people throw up the term stock market, assuming that people actually know what that is. But let’s take them component by component. So first off, what is a stock? Why do stocks exist in the first place? A simply put, stocks are record keeping tools for figuring out who owns how much of a corporation. Let’s make it even simpler, let’s say me and you go into the cookie business together, okay, we do some math and we think that to get the cookie business off the ground is going to take $100,000 in capital. Now I have $20,000, to invest in our cookie business, you have $80,000, to invest in a cookie business, we combined our money together. And there we have our $100,000 however, you put in $80,000 into the business, I only put in $20,000 to the business, therefore you should own 80% of the business and I should only own 20% of the business. How do we figure out that that split out? Well, one way we can do that is by forming a corporation and issuing shares of stock to ourselves. For simplicity, let’s set the dollar price of a share of stock at $1. So your $80,000 buys you 80,000 shares of stock, my $20,000 buys me $20,000 of this stock added up together, there are now 100,000 shares of this of this stock, they trade for dollars, a dollar per share, you own 80% I own 20%. Now let’s fast forward the clock a little bit, let’s say that our venture is successful, we grow revenue, we grow profits, and our venture becomes more valuable over time. Well, five years from now, let’s say my friend, my friend, Anne she decides she wants to become an investor in this business. And she wants to put, let’s say, $50,000 into the stock over time. Well, because we have stock and because our stock is worth $1 price, we can bring on new investors in the future to our venture, and we can issue them shares of stock. And this gets more and more complicated when you add in more and more investors and they’re investing at different periods in the company’s history. So stocks are simply a record keeping tool that allow us to track in simple terms, who owns how much of the corporation at any given time.

Clint Murphy  08:01

And so the value of the stocks represent the value of the underlying company. And we’ll add a little complexity but it doesn’t have to be too complex, and our belief in the value of the future earnings of that company.

Brian Feroldi  08:23

Yeah, that’s that’s exactly. That’s exactly right. When you and I started this business, it was an unknown, it was very risky. We didn’t know if this business was going to work or not. But five years later, let’s say that our business was successful. And the value of the stock rose from $1 per share when we started to let’s say just rose to $5 per share to make things simple. So with Anne buying into our business later, after the business has been proven itself now the stock price we decide is $5 per share. So while she’s investing $50,000, which is more than I put in initially, because the stock price is now $5 per share, she’s only buying 10,000 shares of stock. So now you own your 80,000. I own my 20,000 she now owns 10,000. So instead of there being 100,000 shares in total, now there’s 110,000 shares in total. So even though she invested more money into this venture than I did, I actually own 20% and she only owns about 10% of this business. So by using stocks and having a stock price, it allows different people to make investments into the same investment at different points of time at different valuations and it makes figuring out who owns how much easy.

Clint Murphy  09:43

And that’s that’s an important differentiator you made right there as well. So, for example, you’re on an episode of Shark Tank Shark Tank and you’re playing out what we’re just talking about. A lot of listeners or watchers of the show may think oh they just sold 10,000 shares at five bucks, they just got $50,000 in their jeans. But the way you just demonstrated it, we issued, the company that is, issued the additional 10,000 shares. So that money came into the company, not to the owners of the shares. Can you explain that slight difference in not selling your shares versus the company issuing more shares?

Brian Feroldi  10:29

Yeah, that’s exactly correct. So one thing that a company can do that, that a corporation can do, that we can’t do as people is we can as a corporation can sell ownership in itself. And by doing so it can raise money from investors. So on Shark Tank, they try and make this, Shark Tank is a wonderful show, actually, for learning the basics of this stuff. But they make it extremely easy to do so. So in Shark Tank, they say things like, I’ll invest $100,000 In this business, but I want 20% of the company. So in that case, they’re buying a 20% of all of the shares, enough shares to give them 20% ownership of the total pies, in shares. But yeah, this is one thing that companies can do. Companies can create new shares of themselves from thin air, they can sell those shares to investors, and doing so brings in money to the company. And that money goes right into the company’s piggy bank that it can use to buy inventory, hire people pay for overhead expenditures, etc.

Clint Murphy  11:35

And so as people started to do this more and more historically, where they said, hey, we want to buy and sell investments in businesses, we want to be able to issue stock and do some trades. All the way back hundreds of years 1792, a bunch of people got together in the middle of the street and said, Hey, we want to be able to do this a little bit more efficiently in trading shares of companies. And I believe it was in New York this happened, what what did they create? And why is that relevant to the conversation we’re having now?

Brian Feroldi  12:17

Yeah, the first history of corporations actually predates even the United States, it gets back into the East Indian, Dutch, that company, I forget the name of it, precisely. But the history bakeddates back in the United States into the late 18th century to your point. So corporations have existed for hundreds of years, and shares and corporations have existed for hundreds of years. But once you own shares in a corporation, sometimes people want to sell them, they want to sell their ownership stake that they have in a company so that they can get cash and maybe fund their lifestyle or buy a different investment etc. So in New York, on a street called Wall Street, a group of business owners and investors would naturally congregate with each other, and they would create a market for buying and selling stocks with each other. So get back to our example, let’s say I own again, 20% of our cookie company at $5 per share, my investment is now worth $100,000. Let’s say I want to sell some of that stock so that I can buy myself a Tesla, for example, well, I need somebody to buy those shares of stock from me. So I need to find a buyer of that stock. This problem has existed for hundreds of years. So the way that we solve these problems is by creating a market and that’s all a stock market is, a stock market is a place where business, where corporations and investors meet up with each other in order to buy or sell. Another the word for that is exchange ownership in business with each other. The concept is the exact same thing as a farmers market.  You ever been to a farmers market, you know, there are food producers that go to on the market. And then there are food buyers that go there and they exchange with each other food for money. Stock market is the exact same thing. Businesses have stock, investors have stocks, and they go to this market in order to buy or sell ownership and corporations with each other.

Clint Murphy  14:21

So that’s that’s a super simple example that people can get their heads around is farmer’s market, where they probably start to get confused is and I think it’s for the benefit of the investors is this overlaying on the stock market with the concept of stock market indices, or averages? So when you think of the s&p index or the Dow market Industrial Average, what are those concepts? Why were they introduced and how can they help the investor understand what’s generally happening with the stock market, which represents the culmination of the underlying companies that are on that market?

Brian Feroldi  15:08

Yeah, this is the term Dow Jones Industrial Average. I have heard essentially, since I was a little kid watching the news, I have never heard it explained, I have never heard anybody say what it is. And I’m also convinced a lot of people that say what report on the dow I don’t know what they’re actually reporting on that as my hunch. But let’s get back to our example. So in the United States on a place called Wall Street, the first stock market or one of the first stock markets, the United States was born, this eventually became a more formalized thing and became a more formalized organization. And we now call those bankers, those investors that got together in New York, we call that the New York Stock Exchange, or the NYSE which is the largest stock market exchange in the world today. So these stocks had been bought and sold for a long period of time. And how did investors get information about what stocks were trading or trading for? Well, the answer back then, and up until recently was the same newspapers, people printed the stock name, the stock ticker, and then the price per share in newspapers, that became the record keeping that behind the way that people got information about stock prices. Well, in 1896, the editor of what’s now called the Wall Street Journal, this guy’s name was Charles Dow, and he had was printing these tables in his paper every day about this stock went up this price, this stock fell by this price, and it was just a big table of what was happening. Well, he wanted to find a way to summarize what happened with stock prices that day for his readers, because if you’re just looking at a table, it just looks like garbage, some are up, some are down, you couldn’t get a feel for what happened in the market that day. So he went to his business associate, who was a statistician, his name was Edward Jones. And the two of them devised an idea. What they did was they took 12 of the largest and most well known companies at the time, all of which were industrial companies. And they added up the share price, the ending share price of those 12 companies, then they simply divided the total of that number by 12. Now, what’s it called when you add up a bunch of numbers and then divide by the total number that’s called averaging. So they in 1896, gave birth to the Dow Jones Industrial Average, suddenly, they now had a number that they could share with their readers that would summarize what happened in the stock market that particular day. Moreover, by recording the history of what was happening with this Dow Jones Industrial Average, you could create graphs and charts of what was happening in the stock market, and via one simple a number over long periods of time, and over history by consistently reporting this number through their paper, it became the way that people figured out what was happening in the stock.

Clint Murphy  18:16

And so one of the problems with doing that is we’re using a simple average of only 12 of the companies. So we’re not even take weighting the size of each one on the impact it has, on the whole, Did someone come along and say, well, wait a second, that’s a little too simplistic. We should have more companies in the mix, and we should weight them based on their market size.

Brian Feroldi  18:39

Yes. So you bring up the biggest knock against the Dow Jones Industrial Average. So the reason that the Dow uses the price of one share of stock to figure out what the value is, was simplicity in 1896. People didn’t have calculators, right, these these, these, these numbers were calculated by hand, and they were calculated by hand for long periods of time. So they needed to make it as simple as possible for the people that were calculating this to figure it out. So the easiest way to do that was just by looking at the the dollar price of one share of stock. Now to your point, the dollar price of one share of stock is almost a meaningless figure. Companies can have as many shares of stock as they want, there’s no limit on it. So a company that’s trading at $1 could be a bigger company a more more bigger market cap company than another stock that’s trading at $150. There’s no relation to the stock, the dollar price of one share and the size of the company. So instead, over time, critics have of the Dow pointed out this flaw, and we live in a capitalist society. So in the 1920s, a competitor to Dow Jones called Standard Statistics created an indice of their own, a stock market indices have their own, and they fixed some of the biggest flaws that critics point out in the Dow. So first off, the Dow at the time was only using 12 stocks to figure out what the price of the market was, well, even back then there was way more than 12 stocks in the stock market. So the Standard Statistics created their own index with more than 200 companies at the time. The second thing that they did was rather than figure out what the value of the index is, by looking at the dollar price of a single share, they use the market capitalization. So the total size of the business, which is a far more accurate way of doing so, now, overtime, Standard Statistics merged with a company called Poor’s publishing, creating what is now called Standard and Poor’s. And overtime, they also change their index from just being 200 companies, to 500 companies. So in the 1950s, they launched, they rebranded this index that they launched, called the Standard and Poor’s 500, because it now track 500 companies. And to this day, the Standard and Poor’s 500 is the standard benchmark that almost all managers of fund managers compare themselves to when figuring out their performance.

Clint Murphy  21:16

The s&p 500. And so it’s quite interesting to your point is these things get thrown around, but the history and what it actually is no one really talks about. So I really appreciate that. Now, let’s go back to our cookie example, we’ve had one person buy in 10,000, shares at $5 a share. And now we’re getting to the point where we’re making some serious money. And we think, hey, we want to go big, let’s do one of these things that people call an IPO. So what is an IPO? And why would we make that step and choose that and how does that interface with the stock market?

Brian Feroldi  22:02

So again, his business has three investors, me, you and my friend, Anne. To your point, we’re rockin and rollin, we’re growing like crazy, people are loving our cookies, we are highly profitable. But we have big plans in mind, we want to start opening up retail stores that sell our cookies across the country, because we see a huge opportunity for ourselves. Well, opening up stores requires a big chunk of capital to do so. You need to buy the buildings, you need to design them, you need to hire employees, there’s a lot of upfront investment to bring these stores to life. And that is more it’s going to require more capital than the three of us have on hand. So we decide in an effort to to raise more capital for our business on these growth plans. We take our company, we decided to take our company public, so we work with some investment bankers, they create the investment bankers create new shares of our stock, let’s make the math easy and say let’s say they create 90,000 new shares of our stock, and they sell it to the public at let’s just say a price of $10 per share. So we go, as the IPO happens, we go from being a privately held company where nobody can buy shares, unless they know one of us directly to a publicly traded company. And all of a sudden, our stock price is now quoted on the public market changes, and anybody with money can actually invest in our business. But the key point that you’re getting at is the day of our IPO. But the day before our IPO, we have 110,000 shares in total. But we create 90,000 new shares, we sell them to the public at $10 per share that brings in $900,000 in new cash to our business that we’re going to use to grow. So instead of there being 110,000 shares outstanding, there are now 200,000 shares outstanding, 90,000 of which are owned by the public. That brings us numerous benefits as a public company. First off, it creates a liquid market for our stock. So if you and I, as owners of this business, decide that we want to sell our stock, there’s now a liquid market we can go to to to sell, we don’t have to go and find individual people to buy our investment from us, we can actually sell it directly to the public. Moreover, because we are now a publicly traded company, anybody can make an investment in our business, that raises our awareness within the general public and now people that interact with us can actually become co investors in our business extremely simply. This is exactly what happened to Starbucks, Starbucks had grand ambitions to open up stores all across the United States, so in the 1992, I believe they issued shares of stock to the public, they use that capital to start building Starbucks, and boy has that worked out for investors.

Clint Murphy  25:11

And so if you, if you look at it and you take me as an example, I started off owning 80,000 shares, which represented 80% of the company, then we issued 10,000, to your friend. And so now I owned 80 of 110. And now we’ve issued 90,000. So we’re at 200,000, I own 80,000 of 200,000. So I now own 40% of the business. And from a scarcity abundance, some people hear that and they get a little nervous, they get scared, like, wait, I went from owning 80% to 40%. And then you highlight, that latest round, we sold at $10 per share. So now you say well, wait a second, if I sold my 80,000 shares, at $10 per share, that’s $800,000. And I only put 80,000 in. So the shares have gone up in value over that time that we’ve worked through the company 10 times.

Brian Feroldi  26:23

Exactly. Which is exactly why people invest in start businesses, in the first place. Starting a business starting a corporation allows you to put a little bit of money in to a business and have the overall value of that business increased dramatically in time.

Clint Murphy  26:38

And so the two ways if I look at it, me as the buyer that stock, there are two ways that I can make money in the fullness of time. One of them, the company can pay me dividends, and 2) the value of the shares can appreciate over time. And different types of shares have different attributes, whether they’re dividend stocks, whether they’re appreciation stocks, which we could dive into, but what are those two components, Brian, and how did they work for me as an investor?

Brian Feroldi  27:14

Yeah, you are exactly right. The way that investors can make money from owning stocks is two ways. First, the price of the stock can go up in value, which increases the total value of your investment. The other way that you can make money is if the company uses some of its profits, and gives that directly to shareholders in the form of a cash dividend. But we didn’t go into the fact, we just assumed that the price went from $1 per share. And we started it to $5 per share, when we brought on Anne, and the $10 per share when we went public. The reason that the stock that we that stock go up in value, or the reason that stocks tend to go up in value over time is the underlying business that represents those companies become more profitable in time. To just throw some some numbers on it. Let’s say in that first year of business, again, we have $100,000 in capital, we go out, we start selling cookies, and we make $100,000 in profit in our first year. So let’s say we sell $500,000 worth of cookies, it costs us $400,000 to make, sell, pay taxes, etc, leaving us with a profit of $100,000 in cookies in that first year. Well, we made $100,000 in profit, there’s 100,000 shares,in total, do some quick math on that. And that means that each share of stock has an economic claim on $1. Well, you own 80,000 of those shares. So therefore 80,000 times $1 equals you have an economic claim on $80,000 in profit that first year Me, 20,000 shares $1 per share in earnings, I have an economic claim on $20,000 in earnings per share. And let’s just say that our business, again is successful and that $100,000 grows over time. As that number grows over time, the claim that we have on that profit also grows over time. And that is the primary forcing function that causes stocks to become more valuable. Over time the underlying companies produce more profits over time, thereby increasing the value of each of those individual shares.

Clint Murphy  29:30

And so one of the measures that’s most often cited as it relates to valuing those underlying shares that ties to what you’re talking about right there. Our price is our price and our earnings or otherwise known as the P/E ratio. And then we’ll often hear in the news Warren Buffett, noting that the stock market is far and above its historical P/E ratios. And generally when it crosses this threshold, we’re headed for bad news. So what is the price to earnings ratio? And how can we use the P/E ratio to understand whether an investment in a business makes sense? And why might it differ for types of businesses, whether they’re tax, or industrial, as examples?

Brian Feroldi  30:22

The actual answer to that question can get extremely complicated, quite fast. But let’s just keep things simple. So again, when we started our business, we put up that initial $100,000, there was no revenue, there was no profit, it was purely a venture on our part. So it was an extremely risky decision, we were risking $100,000 not knowing if this company would become profitable over time. But we were successful right out of the gate, and we generated $100,000 in profit, that first year, let’s just say that we kept that $100,000. And that’s when we decided to bring on Anne as our partner. So at the time, our business was generating $1 in earnings or profits per share. And we decided to sell her ownership in our company at $5 per share. So Anne was paying $5 per share, and she was buying $1 in profits per share. So the price to earnings ratio of that deal was five, so price was $5 per share, and it was $1 in earnings per share. When we took the company public, we sold stock at $10 per share, let’s again keep the math simple and say that we were just making that $1 in earnings per share. So we sold stock to the public at 10, P/E ratio of 10 $10 was the purchase price $1 was the earnings per share. Well, that basic ratio, the price to earnings ratio applies broadly across the stock market. In general, if you look back at the history of the s&p 500, the average price to earnings ratio that the index that the s&p 500 has traded at throughout history is about 15, meaning for every $1 in profits per share investors have on average been willing to pay $15 per share to buy into the index. But that is an average. And that ratio has varied wildly over the course of history. At some periods, it’s been an extremely low ratio, literally getting out into the single digits like it did in the early 1980s. And other times that ratio has been in the high 30s or even up to 40 as it was in the late 1990s during the tech bubble. The reason that that number fluctuates has to do with all kinds of macro economic factors such as interest rates at the time, the general mood of the investment community and more. But there are a huge number of reasons that individual companies trade at high P/E ratios and other companies trade at low P/E ratios

Clint Murphy  32:56

And the general mood, so up until now, we’ve been fairly mechanical in talking about the stock market, underlying companies underlying shares, shares of the companies add companies together, now we have a stock market. But once it becomes a stock market, now we’re not trading the underlying company, we’re trading the stocks of that company. And that’s when the human element gets added into the mix. So that is when we start to represent this concept that you talk about that the stock market really is, instead of being the farmers market, now we have a bit of an online auction. And we have this idea of bid ask prices and human psychology. Can you bring the readers up to listeners up to speed? What are these bid ask prices and how do those influence the price of the underlying stock?

Brian Feroldi  33:54

Yep, so in the public markets, again, we sold our stock to the public market at $10 per share exactly. Since this is a market like any auction that is ongoing. There are people that would be interested in buying our stock, but they would want a slightly lower price to do so. Let’s say some investors are willing to buy become an investor in our stock but instead of paying $10 per share, they only want to pay $9.90 per share. Conversely, there are investors in our company that would be happy to sell their stock, but they would only want to do so if they could sell it for slightly more than $10 per share. So let’s just call that $10.10 per share. So in the market, there is something called the bid price. And there’s something called the ask price and those are basically the numbers the buyer would be willing to buy that stock at as well as the seller would be willing to sell that stock at and over time, the eagerness of the buyer and the eagerness of the seller essentially determine what which way the price goes Let’s say me, the seller, I want to sell at $10.10, but I’m I just want to get out, instead of demanding $10.10, I see that somebody wants to buy at $9.90. So I say, okay, I’m okay with that price, I sell the stock at $9.90. Well, the transaction takes place at $9.90. And the value of the stock on the publicly traded exchanges now declines to $9.90, which is the last price that it traded at, well, let’s just say the next day we wake up and investors are in a good mood, and they’re more willing to buy stock, let’s say I’m not willing, they say I’m willing, I just want to become an investor in this business, I’m willing to pay $10.10 to own it. So the next day, the transaction happens at $10.10. Well, that stock price then appreciates from $9.90 to $10.10. So this is why stock prices move around all day, every day, they’re moving up and down to meet the immediate demand for where buyers want to buy at and where sellers want to sell at, and which way the stock goes on that day depends on the mood, or the eagerness of the buyer and seller at that specific point in time. And while on most days, movements are fairly low and predictable. Occasionally, big things can happen in the market that causes dramatic swings in the eagerness of buyers and sellers. And on those days, you can get dramatic moves in not only individual stocks, but as well as the index in general.

Clint Murphy  36:37

And so that really makes me think of this quote from Benjamin Graham, as it relates to the market and it being at least in the short term, what he calls a voting machine. So what Benjamin Graham said was, in the short run, the market is like a voting machine, tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine, assessing the substance of a company. So what was Benjamin getting at there, Brian? And who is this Benjamin Graham guy that we’re talking about for the listeners?

Brian Feroldi  37:16

Yeah, Benjamin Graham is a fascinating figure if you study investing, so he himself was an investor, and he owned a was the leader of an investment fund. And he himself was a big time investor, he really cut his chops in the 1920s, the roaring 1920s. And he got swept up in the mania of the 1920s. If you know anything about stock market history, you know that the stock market peaked in 1929. And then came the worst bear market slash Great Depression in the immediate aftermath of that. And Benjamin Graham from 1929 to 1935, lost a just a ton of money, he thought that stocks were cheap, and he continually invested and the stock market just kept going down down and down. Well, that experience left some deep mental scars in Benjamin Graham’s mind. And he essentially invented the concept of value investing at the time. And his idea became to only invest in companies that had a what he called a margin of safety to them that he felt that he could buy those stocks at a lower price than a rational person would value that business at. And Benjamin Graham went on to teach to become a successful investor over time, and he became a professor at Columbia, in New York City. And he ended up teaching a star student named Warren Buffett who took Benjamin Graham’s class in the 1940s or 1950s, I can’t remember when and Warren Buffett took the lessons that he learned from Benjamin Graham and has essentially become the greatest investor of all time, but that quote that you just highlighted might be my favorite investing, quote, ever. In the short term, the only thing that matters with stock prices is the eagerness and the of buyers and sellers. If buyers are scared, and they just want to get out, stock prices collapse, if buyers are feeling greedy, and they want to get in stock prices can can soar. So anything can happen to stock prices in the short term. But in the long term, it’s really the underlying economics of the businesses that truly determine what businesses are worth.

Clint Murphy  39:27

And so when we look at some of those underlying economics, that drive the long term appreciation in stocks, Brian and we’re focused on price earnings, which means we want earnings to grow. And they have for centuries in that’s because of a combination of inflation, productivity, innovation, international expansion, population growth, to name a few. So can you take our listeners through at a high level, what are some of those things that we just listed off? And how do those compare Ii a country like the United States, versus a country like Japan, where for now probably going on 30 years, 25 years, we’ve been seeing it go in the opposite direction with one of the biggest ones being immigration, population growth, and how important those actually are to society and to the economy in there, the underlying stock market.

Brian Feroldi  40:28

So the premise of my book is, again, that the stock market has gone up in the United States over the last 150 years, about 10% per year. The reason that the stock market has gone up over time is because the businesses that comprise the stock market have, as a group increased their profits over long periods of time, and that increase in profits leads to the increase in the value of the businesses. That was the general point that I was trying to make in the book. But the question becomes, okay, why did these cut? why do companies become more profitable over time? And the key question, why should we expect that companies will continue to become more profitable over time. I lay out seven criteria, seven criteria that each work together to increase corporate profits over time, those factors are number one, inflation, number two, productivity, number three, innovation, number four, international expansion, number five, population growth, number six acquisitions, and number seven stock buybacks. Now, in any given year, each of those forces only contribute one or maybe 2%, to the overall earnings growth of the underlying indexes. But when you add them all together, and you compound them over long periods of time, those forces work together to drive up the economic profits of companies that make up the in the stock market. And over time, that is the weighing machine portion of that quote, that keeps improving in value over time. So as long as those seven forces remain in place, we should expect that the essence that the US stock market will continue to rise, hopefully indefinitely.

Clint Murphy  42:16

And you said the word right there, that’s always magic to my ears, I wrote a thread on it recently that went viral. And it was compounding the eighth wonder of the world. So when you went back and you started, the conversation was saying you could put $400 a month, you’re putting that into your stocks, and over your investing horizon that leads to millions of dollars by the time you retire. The big part of that is compounding. What is it and how does it make our investments go up in a supercharged way, in the fullness of time,

Brian Feroldi  42:56

Yeah, compounding is a wonderful term. And Einstein did call it the eighth wonder of the world or the most powerful force in the universe, I’m gonna butcher his quote, but the compounding occurs when the proceeds that you get from an investment are re-invested into that investment over and over again, to generate increasing returns over time. So Benjamin Graham has a great quote on this. And he called that money makes money, and then that money makes money, and then that money makes money that makes money. And that continues indefinitely. That is the magical force that the stock market enables small amounts of money to turn into large amounts of money over time. So the idea is to make things simple, you invest $1,000 in the stock market, and then it goes up 10%, you now have $1,100, if you get a 10% return that following year, well, instead, you’re not making $100, you’re making $111 Because that extra $100, that your first investment got is also increasing in value over time. And if this keeps happening again, and again, and again, suddenly the base of your investment is growing at an exponential rate. And the returns that you’re getting at the investment are also growing at an exponential rate. And if you look at all the great fortunes that and built over time, it’s all due to the the nature of compounding, some people have gotten it by investing in the stock market. A lot of the richest people in the world have got it through reinvesting in their own private businesses. But it’s really compounding, the compounding of an investment that leads to massive gains in wealth over time.

Clint Murphy  44:38

And that’s why Brian when we have that little box that says do we want to reinvest, if we have dividends or we have interests, we always want to tick that box so that when we get paid our dividend or we get paid our interest payment, it just goes back into the underlying investment. So now we have the money earning money on money on money. And this brings up the old adage, you want your investments to be making money while you sleep.

Brian Feroldi  45:07

That is exactly correct. That’s a big mistake that people can make is they can put they pull their money out, or they don’t choose to reinvest their dividends and even if it’s a small percentage, say, two or 3% per year, it doesn’t seem like a big deal to pull those out. But if you are in the asset accumulation mode, one of the best things that you can do is to reinvest your proceeds that you get from investments back into that investments, which really turbocharges their long term growth.

Clint Murphy  45:34

And so as you think about that beginning investor, they they often get scared. Because even though we’ve broken this down, and it may seem okay, now that you guys have talked about it, it seems much simpler than I thought to begin with. But they get afraid of, well, what type of account do I put my money into? And then when I’ve got my money in that account, the first problem often is someone will say to you, well, Brian, I put, in Canada, we have RRSPs, you have 401k’s and you have Roths, they’ll say I will I put my money into my 401k. And you say, Oh, great, well, what did you invest it in? And they’re like, well, well, my 401 K. And it’s oh, oh, no, like once it’s in there, you actually have to then buy an investment. The account is one thing, the investment is a number is is another story. So what type of account should the average American be thinking about? And then once they have their money in that account, what are some of the most basic investments that we can guide them to, so that they can get rid of some of that fear and start investing?

Brian Feroldi  46:44

Broadly speaking, there are two types of accounts that you can put your money into if you do want to become an investor in the stock market. They are tax advantaged accounts, and regular accounts. Now there are many different flavors of tax advantage accounts, you point out the United States, we have the most popular tax advantage account is called a 401 K, which is a tax advantaged investment vehicle that is typically set up by most people’s employers. So they they automatically pull a little bit of their paycheck, they put it into their 401K, and that money grows tax free over time, and then they pay taxes when they take it out later in life. So the 401K is typically the first place that people look at when they’re going to make investments into the market. The biggest reason that most people put their money there is that a lot of employers in the United States choose to add extra money to an employee’s account, if they choose to invest in there, it’s called the employer match and taking advantage of the employer match with at your 401k should be the first choice for almost everybody that has access to one in the United States because it’s literally getting free extra money invested on on your behalf. Beyond the 401k, another popular choice in the United States is called an IRA individual arrangement or individual retirement account. That’s actually not what it’s called, but as individual retirement arrangement or something like that, but everyone just calls it an IRA. And those are also tax advantaged vehicles, there are also different levers of those that you can put money into. And beyond that, there’s lots of different tax advantaged choices that you can do. If you don’t want to go the tax advantage mount, you can just go to Charles Schwab or Vanguard or Fidelity or any of the brokers that are out there, and you can just set up what’s called a regular taxable account. The downside to doing that is that you have to pay taxes on any investment gains that you have, or any dividends that you get the upside to doing so is that you don’t have to wait till you’re 59 and a half or any in your retirement age to access and pay for the funds. There are pros and cons to each. As for the investing in themselves, you brought up an excellent point which is 401Ks and IRAs, those are wrappers around the account. That’s the type of account that you have. Putting money into one of those doesn’t automatically mean that you are invested in the stock market that you like think, it’s kind of like putting money on to a Starbucks gift card. If you just blow the money on the Starbucks gift card. That doesn’t mean that you’ve bought coffee. All you’ve done is put money on the gift card, to actually buy coffee have picked that gift card and swipe it just similar with a 401k. Putting money into a 401 K is step one, but then you have to take step two which was take the money in the 401k and buy an investment with it. The most popular way to invest and the most the easiest way to invest is to buy what’s yours called index funds, which are very low cost, easy to access, o thinking of funds that mimic an index. The most popular index to mimic is the s&p 500 that we talked about before so if you buy if you put money into an s&p 500 Index Fund, you are instantaneously buying five shares in 500 companies with a snap of a finger and doing so tends to be extremely low cost and you’re guaranteed to essentially mimic the market’s results over time.

Clint Murphy  50:15

And when you think of those index funds, they represent simply the underlying market and generally low fee. So an important thing for people to think about because often, they’ll see mutual funds, which was the historical way of investing. But a lot of the research shows that mutual funds will generally underperform the market as a whole. Can you share with the readers the important driver of why the mutual funds will generally underperform simple index funds and why we suggest that route instead?

Brian Feroldi  50:49

Yeah, the data clearly shows that somewhere around 85 to 95% of mutual funds, people that meaning active managers that are trying to outperform an index over time failed to do so over long periods of time, over short periods of time, it’s more common to do so. But over long periods of time, most mutual fund managers lose to the index. There’s actually a number of reasons that that that happens. But two of the other biggest are first off is fees. Typically, a mutual fund has a fee of about 1%. Whereas a typical index fund has a fee of about 0.1%. So right off the bat, mutual funds have a 1% drag on them that index funds don’t and that right there 1% might not sound like much, but when compounded over long periods of time that 1% is a huge difference. The other problem that mutual funds have gets down to the principal agent problem were basically the investors in the fund and the managers of the fund have different incentives that are underlying them. And that difference in incentives is a big is a cause of some mutual fund underperformance. What do I mean by that, if you are a fund manager, the way that you make more money from yourself is gathering more assets, a fund with $10 million in assets will make 1/10 of the amount of money of a fund with $100 million in assets. So the fund managers make all of their money by gathering and retaining assets, not necessarily by outperforming the fund over time. So fund managers are kind of like are kind of like politicians. A fund manager’s in the asset gathering business, just like politicians are in the vote gathering of business. So a fund manager will typically focus a lot of their time on gathering assets and convincing people to invest in the fund, as opposed to spending their time managing the fund itself. That’s, of course, a broad statement, there are plenty of really good fund managers out there. But that’s just one principal agent problem that a lot of fund managers have. The other problem that fund managers face, which is a huge problem is the quality of the investors that they gather, you could be the best mutual fund stock picker on the planet. But if everybody plows money into your fund in 1999, and then everybody takes money out of your fund in 2002, you the fund manager have this huge influx of capital when stock prices are high. And you have this huge pull out of capital when stock prices are low. So the behavior of your investors, the mutual fund managers, investors themselves is outside of the fund managers control and they have to do things to deal with that volatility of the investors themselves. So a combination of factors make it’s just the natural setup of the industry make it extremely hard for mutual funds to outperform the index over time. This is why the standard advice has become just invest in the index funds themselves and you’ll outperform, which I think is just great advice.

Clint Murphy  54:06

That’s really important when you talked about that idea that the mutual fund managers are in the business of growing the asset base, because when you look at a lot of the ability to generate oversized returns, when their fund is small, is having that ability to be nimble and to place the capital into companies that can generate an oversized return based on the fundamental analysis you’re doing. But the more capital that you bring in, the ability to place it into a smaller company to generate an oversized return starts to disappear because you simply have too much capital. Now you have to go for bigger companies to generate that same return and they may not have that same short term upside to that smaller investment you were able to make to generate a return early on. So you start to become a prisoner to your success.

Brian Feroldi  55:05

Yep, you got it. And to make things matter even worse, how do people, how do everyday investors judge the performance of mutual funds, you can say whatever you want people look at short term recent returns, when they’re making investment decisions. If a fund goes up 40% in one year, that fund is going to get a ton of capital, if another fund goes down 40% in one year, investors are just going to pull money from that capital. So investors are hyper focused on the recent performance of the fund when they are making decisions. So let me ask you this, pretend for a second that you were a real estate investor, you started a fund and your entire way that you are going to make money from this, the way that I’m going to pay you for managing this Real Estate Fund is just the number of properties that you buy, that is the sole metric that I’m going to pay you on you, you acquire more properties, you’re going to make more money. And the only way that I’m going to tell if you’re doing a good job or not, is the 30 days Zillow prices of the properties that you that you bought right. So you’re going to do it under that scenario. You’re going to do everything in your power to buy as many properties as you can and figure out how to game how the Zillow estimates work so that you can maximize the the short term movements of the property of value. Now me the real estate investor, the way that I make money is are you buying good properties? Are you managing the tenants well? Are you bringing in revenue from those tenants? So just by the structure of the fund that we set up, you have a completely different focus and incentive than me the investor, to me that summarizes the mutual fund industry are on the surface, it looks like the investor and the mutual fund manager are aligned. But when you dig into the details, fund managers have a certain set of incentives that makes it almost impossible for them to perform well in the long term.

Clint Murphy  57:02

And when you think about now flip back to index funds. I was actually surprised to learn that when Jack Bogle created index funds, the only way to do it because of because there’s no fees, they actually lose money. So when he set up Vanguard, it was as a not for profit is my understanding. Do people understand what type of advantage he was giving to them by doing that?

Brian Feroldi  57:39

Yeah, I mean, Jack Bogle is the patron saint of investing. What he did at Vanguard literally has transferred billions of dollars in wealth that he could have personally had to the investors in his fund. So Vanguard has a very unique structure in that the owners of Vanguard, of the company are actually the investors themselves. So that ownership structure that he set up, gave Vanguard a unique advantage that has turned it into the investment juggernaut that it is today. One other side note on that structure, widely regarded to be the best investor of the last 70 years is Warren Buffett, right? The way that Warren Buffett has set up his partnership is through investing in publicly traded companies or in companies themselves. But he himself runs a publicly traded company, he did not go out and start a fund himself, right. So because of the nature of the company that he was investing through, essentially the insurance float, he was investing with permanent capital, he himself was investing with permanent capital. And if you wanted to invest alongside him, you simply bought stock in his publicly traded company, that structure is completely different than it would be if he himself set up a mutual fund that you invested in to gain access to his investments. So I believe really strongly that the way that he structured his investment vehicle provided him with a massive advantage if he was just a fund manager or a hedge fund manager.

Clint Murphy  59:12

Absolutely. And there was also some tax advantages from losses in the textile industry that he was able to take advantage of with Berkshire Hathaway. So when it comes to financial advisors or robo advisors, because we’re not necessarily saying you shouldn’t ever involve anyone in your investments, there may be a time and a place to do it. What are some of the things people should be thinking about if they’re going to use a financial advisor or a robo advisor and why might you advise them to use one?

Brian Feroldi  59:46

Yeah, the key question to me is should you work should you work with an advisor or not is do you have the time the energy and the inclination to become your own financial advisor. Does investing, does managing your finances, is that something that interests you? It takes work to do so and you have to, to know yourself. For the vast majority of people, the answer to that question is, no, I’m not interested in becoming my own financial advisor. So for those people, it is perfectly okay for them to go out and work with an investment advisor. If you’re going to go the investment advice route, it is super important that you find an actual investment advisor and not a salesman. And broadly speaking, there are more salesmen and salespeople that claim to be investment advisors, then there are actually investment advisors. To whittle through that maze of picking an advisor, or there’s a couple of steps that you can take. I outlined many of the questions in my book, but the two biggest one to me is asking them one, how do you get paid? And two, are you a fiduciary, if somebody is a fiduciary, they are required to put your needs the client needs ahead of their financial needs. And 2) if you, you have to understand how that person is making money off of you. I personally have talked to a lot of my friends. And I’ve asked them that I’ve worked with financial advisors, I’ve asked them, How do they get paid, and I get blank stares the entire time when people say I don’t know how my advisor is making money. And I say, Okay, would you go to a mechanic? Would you use a mechanic if they just pulled money out of your your bank account after they did repairs and hey didn’t even send you a bill? Like no, of course you wouldn’t do that. But that’s how it works with a lot of financial advisors. So are you a fiduciary and how do you get paid? Answering those two questions will really do a will really go a long way to making sure that you’re working with somebody good.

Clint Murphy  1:01:46

And a last question on the book. And I can’t believe I hadn’t thought about how do you get paid? That’s now filed away in my brain. The last question on the book is what are two or three of the most common investing mistakes that you see? And how do we avoid them?

Brian Feroldi  1:02:03

There are lots of ways to screw up investing and I myself have screwed up investing a ton of different ways, I would say that the biggest mistake that people make by far is they never get started investing in the first place, it is the most powerful time to start investing is when you are young. The more time that you have on your side, the more powerful the dollars are that you are putting work in the market. Over the time that people when people are young, that’s typically when their incomes are low, and they have all these big expenses on the horizon, maybe they’re getting married, maybe they’re moving around the country, maybe they’re buying a house, buying a car, maybe they’re paying for education, and their income is likely to be really low. So it’s very common for people that are in that stage of life to just avoid investing because they want to take every dollar that they have and use it for their life, then it’s very common for many people that don’t do that in their 30s 40s or 50s to still not start investing because they always are using their capital for other things and for living their life. So the biggest mistake that I see people making by far is just not starting investing in the first place.

Clint Murphy  1:03:13

And so Brian, to finish up, I’ll throw some rapid fire questions at you, four rapid fire questions. The first one being what’s one book you’ve read that’s had an oversized impact on your life? And you might have already told us this one.

Brian Feroldi  1:03:29

Well, so yeah, so there I’ve read tons of amazing books out there. Again, the book that started me on this journey was Rich Dad Poor Dad. And that was really a story book that got me interested in investing. Today, there are many things in that book that I disagree with. So I don’t think it’s the best book for for people to to start with. However, it is the book that I owe a lot to simply because it introduced me to the concept of investing.

Clint Murphy  1:03:57

Okay, and what’s on your bookshelf right now? What are you reading that you’re enjoing.

Brian Feroldi  1:04:04

This is a portion of my bookshelf behind me. But I am constantly on the lookout for great reads related to money and finance. I’m always finding stuff. Uh, one book that I read recently that I really liked if you’re an investing nerd, like I am, was Investing for Growth by Terry Smith. Terry Smith is actually a mutual fund manager. He’s the manager of something called Fundsmith. And he to me is one of the best mutual fund managers in the world. So that’s a collection of his shareholder letters. And he dispels some just great investing wisdom. So if you’re interested in investing in individual companies like I am, I think that’s a great read.

Clint Murphy  1:04:41

Terry Smith investing for growth. Thank you. What’s one thing that Brian has spent less than $1,000 on in the last 12 to 18 months that’s made you say Darn, I wish I’d bought this sooner?

Brian Feroldi  1:04:54

Oh geez, the list of things that I’ve bought that that I have really enjoyed. ‘m generally a frugal person. And over the last couple years, I’ve become less frugal over time. So one thing that comes to mind is I finally subscribed to Audible. Audible is something I’d heard about for more than a decade and I was just like, No, no, no, no, I finally fell down the rabbit hole, do a premium subscription. So I can now get audiobooks. And I am someone that goes for what many walks, I walk every single day for at least an hour and I listen to podcasts, but I’ve added audiobooks from Audible to that list. And now I’m kicking myself to say what the hell took me so long

Clint Murphy  1:05:33

And are you doing primarily nonfiction? Are you also throwing fiction into the mix?

Brian Feroldi  1:05:37

I like both. For me, I, when I have time spent for leisure, I’m almost always going after educational material. So I like nonfiction. If I’m going to listen to a work of fiction, it better be a damn good work of fiction that really interests me. So my bar for fiction is extremely high. So most of my most of the things I listened to are nonfiction.

Clint Murphy  1:05:59

Dome fiction ones that I’ll throw at you for fun are anything by Neil Gaiman. And you may have heard this, he because the books are interesting, but he narrates them himself. And it seems a little unfair that he’s such a good fiction writer. And one of the best narrators I’ve ever heard. He wins awards for narrating and his voice as he narrates these books, it’s just absolutely fantastic. Tim Ferriss recommended The Graveyard and I listened to it, and I was just thrilled by it. So I went and picked up another two or three. And then Kevin Hart, narrating his autobiography, because he, because he’s narrating it. He’s not afraid to ad lib certain sections of his own autobiography and tell you funny stories. And he’s just a great comedian. So him doing it, it’s having having them add their voice to the book, just takes it to a whole new level. And because this show is about growth, what’s something that whether it’s a mindset shift, a habit change, or a behavior change that you’ve implemented in your life, that has had a tremendous positive effect for you.

Brian Feroldi  1:07:17

So the word growth can be used on many different things. But broadly speaking, I am someone that spends a huge amount of mental energy thinking about money and investing. That’s just a subject that naturally really interests me. But one of the biggest changes I’ve made to my life over the past 10 years related to growth that has dramatically increased my happiness relates to the way that I find and relate with find friends, and form relationships with friends locally. So I have become known locally as the guy that organizes events. So I organize Weekly Trivia meetups, I organize parties. I’m very active in my kids Elementary School. Tonight, I’m hosting a Bingo Night at the school for 300 people. So I’ve become gone way out of my way to be the one that makes plans for people. And because of that my friendship circle has just exploded. And that has delivered more joy to me than almost anything else I’ve ever done.

Clint Murphy  1:08:13

That’s phenomenal. I love that. And after reading, you mentioned Nick Gray’s episode, it made me want to get more more involved in doing that. And then at the same time, as an introvert, it scares the crap out of me. So thank you, Brian, we went pretty deep into the book. And it was a great primer for people on the stock market, as was the book. Is there anything that we missed that you want to make sure the listener gets?

Brian Feroldi  1:08:39

No, I think you did a pretty good job covering it. I can I can just say that. I wrote the book. The book is extremely simple. I wrote it that way on purpose. I wanted it to be an onboarding introduction that takes someone that knows absolutely nothing and introduces the basic concepts to them so that they can they can understand how to take advantage of the stock market, which to me again, is the greatest wealth creation machine ever invented.

Clint Murphy  1:09:02

Excellent. And where can our listeners find you Brian?

Brian Feroldi  1:09:06

Sure. The best way to connect with me is on Twitter. I’m @BrianFeroldi. If you’re interested in signing up for my newsletter, which just drops one quick investing or concept per week. That’s just at Brian for all the.com

Clint Murphy  1:09:19

Excellent. And we’ll get both of those into the show notes. Thank you for joining me today.

Brian Feroldi  1:09:24

Thanks for having me, Clint.

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