No Need to Hunt

Podcast (.wma format)

When people ask me what their first stock investments should be, I suggest they consider a mutual fund that follows a large stock index, like the S&P 500. Such funds are readily available and often inexpensive.

Most importantly, they're broadly diversified. The S&P 500 tracks the value of 500 companies representing about 75% of the US equities market, according to Standard and Poor's (which manages the index).

Of course, in times like these, with a volatile stock market, occasionally someone will ask me, "But what if all those companies go bankrupt?"

A very unlikely scenario
I tell them, "These are 500 of the largest companies in our economy. If they all fold, you won't need investments. You'll need to know how to hunt."

The recent market turmoil has people thinking about doomsday scenarios. But while stock prices may continue to drop in the short run (no one knows for sure), I don't believe there is any need to worry about broadly-based indexes becoming worthless.

When it comes to investments in equities—stocks and the mutual funds that own them—nothing is guaranteed. But in my professional opinion, only a complete breakdown of our economic system could cause a failure of all these companies at once.

Business has to work
Here's why that scenario is so improbable. A complete economic failure would mean that no one would be paying for cars, or paper, or food, or clothing, or rent. There would be a complete halt to trade, an end to most of the benefits of division of labor. So if I want a pretzel, I'd have to grow my own wheat, harvest it myself, mill it at my own mill, add salt that I mined myself, and bake it in my own oven with fuel I provided.

Do you really think that's what lies ahead? I don't. I'm not good in the kitchen, so it's better for me to buy a pretzel from someone who's good a baking them. He buys his flour from from the miller, who buys her grain from the farmer, who gets water piped to his south 40 by the county that collected taxes to pay for the water distribution system.

As long as people don't want to do everything for themselves, they'll be willing to trade something of value (money, for instance) in order to have what they want. And as long as sellers can make more money by meeting the wants of others than by putting their cash in the bank, businesses will be around to sell us goods and services.

Naturally, this makes it highly unlikely that our economy could collapse all at once. As long as there is still profit to be made by doing a job better than other people can do it, there will be people willing to pay for it. That's how business, and human nature, both work.

What works for business works for investors
When you buy a stock, you become a part owner in a business. When the company makes money, the value of your share of the company goes up. And as a part owner, you are entitled to a proportionate share of the company's profit. After all, profit is why companies are in business to begin with.

When you buy a broadly-based mutual fund, you are a part owner in many businesses. If your fund does a good job tracking the economy as a whole, then as the economy thrives, so does your investment. And if one company in the mutual fund folds, you'll almost certainly have many others that are still profitable holding up the value of your investment.

Tough times come and go, and these tough financial times will get better. No, I don't know when. But you don't need to learn to hunt just yet. The recent turmoil in the stock market isn't a sign of doom. It's merely the natural response to a challenging economic situation. Our economy has survived hard times before. I'm convinced it will survive this time as well.