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ELI5: The Stock Market

Today we get back to basics and answer some of the most common questions about the stock market.

Mug Madness, The Endowment Effect and Your Finances

In a 1991 study , researchers randomly divided Cornell University students into two groups. One were gifted mugs, the other received nothing. The fortunate group were asked how much they're willing to sell the mug for. The mug-less were asked how much they were willing to pay. The owners were unwilling to sell for anything less than $5.25 . The buyers on the other hand, were unwilling to pay more than $2.75 . The seller's expectation was almost twice the buyer's market. This is a classic example of the endowment effect , the tendency for us to irrationally overvalue items we own. A 2000 study  demonstrated an even greater expression of the endowment effect. Duke University conducts a lottery for basketball tickets before critical games, as demand greatly exceeds supply . After one of these lotteries, researches called up a random group of winners and losers to ask about selling and buying prices respectively.   Sellers on average expected over $2,400 for their t

96 Percent: Most Stocks are Bad Investments

Hendrik Bessembinder , finance professor from Arizona State University studied stock returns from 1926 - 2016, looking at all public companies listed on the NYSE, AMEX, and NASDAQ. He found that most stocks are weak investments. Many not even strong enough to put up a fight against  Treasury bills . Stocks as a whole have generated tremendous wealth. The total US stock market is worth over $ 30   Trillion . However, Bessembinder discovered most stocks don't contribute much. Most are under-performers that piggyback of the performance of a few key players ( like group projects in school ). Just 4% of companies account for all stock market returns. While the remaining 96% failed to have much of an impact, their gains and losses washing each other out. Approximately 25,300 companies were studied and a small number of top performers account for a   disproportionate percentage of the market's return. # of Top Performing Companies % of Market Return 5 10% 30

For Real? The Really Real Returns of Real Estate

Despite what your parents tell you, a house is not an investment. It's a depreciating asset. A house, like any physical asset lose value over time. They age and wear down. To slow down the depreciation, you need to constantly throw money at it for maintenance. This is simply to maintain the value, not to increase it. Houses without maintenance is like an unrefrigerated milk, it goes bad fast . Take a look at any abandoned home. After only a few months you see damaged roofs, clogged gutters, cracked windows, and probably some unwelcomed furry tenants. Maintenance can be pricey. A conservative rule-of-thumb is 1% of your home's value annually. So if your home is valued at $500K, you should budget $5K a year for maintenance. Obviously this is a ballpark figure and should be taken with a grain of salt. Your cost will vary depending on a number of factors such as home age, weather conditions, etc. You've heard the stories from friends and family, homes doubling in val

Survival of the Fittest? Survivorship Bias in Investing

If you've ever sat down with a big bank " financial advisor " to discuss funds, you might've been amazed by the market-beating returns they advertised. Look at all those gains? Take my money! Before you go all in, you should ask yourself: Is this too good to be true?  What about all the research showing how most active funds fail to beat their benchmark?  Market data has repeatedly shown that an overwhelming majority (< 80%) of active managers fail to beat their benchmark over an extended time period. So why do these funds look so good? The answer is survivorship bias . Survivorship bias is looking only at winners (and ignoring the losers) to formulate your opinion. This leads to an incredibly inflated view of reality. When funds perform poorly, they fall out of favour. They struggle to attract capital and eventually shut down. When these funds vanish so do their performance record. What remains are the strong performers with the attractive (i.e. m