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3 Stock Market Tips from an Economist

Recent volatility has Americans talking about the stock market — and getting a lot of things wrong in the process. Let’s discuss some general principles to help clear things up.

(Let me say up front that I won’t be disclosing which stocks are going to go up next month. Even if I knew, it would ruin my advantage to tell everybody.)

1. Money doesn’t go “into” or “out of” the stock market in the way most people think.

On NPR’s Marketplace, after the recent big selloff, host Kai Ryssdal said, “That money has to go somewhere, right?”

This language is misleading. Let me illustrate with a simple example.

Suppose there are 100 people who each own 1,000 shares of ABC stock. Currently, ABC has a share price of $5. Thus, the community collectively owns $500,000 worth of ABC stock. Further, suppose that each person has $200 in a checking account at the local bank. Thus, the community owns $20,000 worth of checking account balances at the bank.

Now, Alice decides she wants to increase her holdings of cash and reduce her holdings of ABC stock. So she sells a single share to Bob, who buys it for $4. There is no other market action.

In this scenario, when the share price drops from $5 to $4, the community suddenly owns only $400,000 worth of ABC stock. And yet, there is no flow of $100,000 someplace else — certainly not into the local bank. It still has exactly $20,000 in various checking accounts. All that happened is Alice’s account went up by $4 while Bob’s went down by $4.

2. Simple strategies can’t be guaranteed to make money.

Suppose your brother-in-law says: “I’ve got a great stock tip! I found this company, Acme, that makes fireworks. Let’s wait until the end of June, and then load up on as many shares as we can. Once the company reports its sales for July, we’ll make a fortune because of the holiday numbers.”

Clearly, your brother-in-law would be…

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