I occasionally run into people who don't really understand what the stock market is. I think they have this vision of a casino where you walk in and bet it all on red and then hope you score. They view it as a gamble. I don't see it that way at all and because of that, will likely invest in the stock market until the day I die.
Why I Invest in Stocks
However, the reason I invest in stocks is not “because the stock market goes up”. Has the stock market gone up over the long term? It sure has. Is it likely to continue to rise in the future? Absolutely. Check it out. The oldest stock market index is the Dow Jones.
Note that this graph is logarithmic. But look at that trend! Do you REALLY want to bet against that in the long run? But isn't a lot of that just inflation? It sure is. But what happens when you subtract inflation out from stocks and some other frequently used asset classes?
Inflation is a great reason to INVEST IN STOCKS, not avoid them! It's one of the main reasons you invest, not a reason not to invest. Perhaps people claim that the US stock market is just a historical exception. Well, the data doesn't seem to support that conclusion.
As you can see, the US was definitely one of the winners of the last century or so with its world wars and depressions, but even an average country saw a return of 4-5% + inflation.
Why the Stock Market Goes Up in the Long Run
Clearly, at least in the past, the stock market has gone up. But WHY? Why does the stock market go up? Does it go up for the same reason that Beanie Babies went up?
A couple in divorce court in 1999 dividing up their Beanie Babies
Or that Bitcoin went up?
Mostly no. To understand why, it helps if you first understand what the stock market is.
What Is a Stock?
A stock is a share in a company. If you buy one share of Apple or Exxon or Walmart, when those companies make money, you make money. It's really that simple. When you invest in the stock market, you are investing in (mostly profitable) companies. They actually provide goods and services that people want and are willing to exchange money for. When they are well-run, they not only continue to make money each year, but they make EVEN MORE money than they made last year. Let's take a look at some well-known ones. How about Walmart?
This is what Walmart's gross profit looks like if you go back to 2006. Not only does Walmart make a heck of a lot of money (those are BILLIONS on the left), but they make MORE money each year.
Does this look like a business you would like to own? It sure does. Think of what you could do with an income of $129 Billion! Now, to be fair, this is just gross profit, which doesn't actually include their substantial operating costs. Their net income was a little under $7 Billion. But an income of $7 Billion still seems pretty good to me, so I'm going to buy this company.
Let's see how much it costs. Looks like $296 Billion. Oh man, that's a lot of money. I don't actually have that much in my bank account. How can I possibly buy this company? Maybe I can find some friends to go in on it with me. It turns out it takes a lot of friends to come up with $296 Billion. That's where the stock market comes in. Not only can I find enough friends there to buy the whole thing, but I can buy as much or as little of it as I want and, if I change my mind, I can sell it at any time the markets are open. Cool trick, eh?
Now how do I make money? Well, as Walmart generates profits, it pays some of those profits out to the owners like me (these are called dividends.) It also uses some of the profits to reinvest in the company so it can build more Walmarts and make even more money. Or sometimes it just holds the cash in its company bank accounts or uses it to buy back shares of stock from other owners. All of those actions increase the value of the company and correspondingly, the value of the tiny little share of it that I own. So I make money from the dividends it pays out each year and from an increase in the value of my portion of the company.
What Makes A Stock Go Up?
So now that we know what a stock is, why does the price for a stock go up? I mean, isn't the value of a company just the value of all of the future dividends of the company, discounted for the fact that I won't receive many of them for years? That's exactly right. If a company makes the exact same amount of money every year, the price of that company should not go up. And thus the price of all of the companies whose shares are being traded on the stock market should not go up and the stock market should not go up. So the reason the price of a company goes up (and the reason the stock market goes up over the long term) is because it makes more money.
In financial terms, a company is really only worth the return on your money that it can generate. There are basically three sources of return when it comes to owning a company:
- The profits the company spits out (i.e. the dividend yield or the dividend paid out divided by the value of the company)
- The increase in earnings of a company (i.e. the rate of earnings growth)
- A speculative component (i.e. price to earnings ratio, or how much people are willing to pay for a dollar of earnings)
In the short-term, the third component has the largest effect. In the long-term, that effect goes down to nearly zero (and can thus be ignored) and the first two components are the primary drivers of investment return.
One Stock vs the Stock Market
The stock market is made up of thousands of companies. Some will grow, some will shrink, some will disappear, and some will be created and join the market in an Initial Purchase Offering (IPO) when the creators and previous owners of the company sell part of the company to the public. The collective fortune of the market depends on how the sum of all of these thousands of companies do. If, on average, they continue to make money each year and continue to increase the amount of money they make each year, then the value of the overall market will rise.
Thus, you see the stock market is not a casino, at least in the long-term. It's just the place you go to buy profitable companies. In one respect, it is a bit casino-like. This is due to the costs of transacting in the market.
These can be:
- bid-ask spreads (the difference between what a seller gets and a buyer pays—i.e. how the market itself stays in business)
- commissions
- advisory fees
These costs are a drag on the returns of the investors in these profitable businesses. A great way to boost those returns is to limit these costs by limiting how often you (or your representatives) go into the casino. If you buy Walmart today and don't go back for thirty years to sell it, those costs will be trivial. If you're there every afternoon swapping Walmart for Exxon, they're going to add up quickly.
An index fund is a mutual fund (a bunch of investors pooling their money together and hiring a professional to manage it) where the manager simply buys all the stocks being traded on the market and holds on to them, passing on the dividends to the investors and providing economies of scale and liquidity.
Investing in a well-run, low-cost broadly-diversified index fund gives the investor the market return, but the investor is not actually investing in the stock market. She is investing in companies that are traded on the stock market. She owns them. You own them. When you drive down the street past McDonald's and Home Depot and Walmart, you can point out to your kids that you own those companies. Maybe they do too if they have a 529, or a UGMA, or a Roth IRA, or some other type of investing account.
Why Companies Will Continue to Make More Money
So now that we have seen that in the long run the fortunes of the stock investor (particularly an intelligent one buying and holding an appropriately designed portfolio of low-cost index funds) depend primarily on whether the companies on the stock market continue to make money and especially if they continue to make more money each year, is that likely to happen? Yes, yes it is. Let's talk about the reasons why.
# 1 Inflation
Inflation has been with us for a long, long time and is probably not going to go away for any lengthy period of time. In fact, our government and banks are actually trying to keep inflation going. They aim for an inflation rate of around 2% per year. You have probably noticed that the cost of cars, food, gasoline, houses, health care, and education continue to rise each year and will probably continue to do so.
Guess who supplies all that stuff? That's right; in large part, it is those corporations whose shares are traded on that stock market. If you're paying more for that stuff each year, then the company is making more when they sell it. As we have seen above, when the company makes more the value of the company goes up. So the price of these companies generally goes up with inflation just like the price of food and cars, and that is one reason why companies will continue to make more money each year and the stock market will continue to rise.
# 2 Increasing Population
Perhaps you've seen a chart like this:
You may have noticed that your city is getting more crowded. Now some of that is just the fact that people are moving from small towns to big cities. But a large part of it is just that there are more people around. Those pesky doctors and public health folks keep dropping mortality rates at a faster rate than we decrease the number of babies we're making.
But if you thought growth was bad in your town, you should realize that every other part of the world is growing at an even faster rate. All of those people also want food, gas, health care, and iPhones that the companies you own provide. More customers equal more profit equals rising stock prices equals rising stock market.
Now, could that trend change? Sure. Some people even predict that it will over the next couple of centuries.
So maybe that will have a drag on how much more money those companies you own can make each year starting in 2075 or so. Oh, you'll be dead by then? Me too.
# 3 Improved Productivity
Guess what? All that technological change and knowledge is making us even more productive than we used to be. How about this chart?
We used to spend all our time and energy growing the food we needed to eat. Now we can spend it on something else. Now granted, some of us are going to spend it in the basement on The Legend of Zelda or Call of Duty, but many of us are going to come up with all kinds of new products and services that can improve our lives and those of others.
Airplanes and cell phones and the internet and robots and all of the other ways productivity is increased boost the fortunes of these corporations, and thus their owners. There are very real social and political costs to increased productivity, but there is little doubt that it is a factor that increases the value of the stock market.
# 4 It's Not a Closed System
Here's another important factor. The stock market is not a closed system. There are inputs into the system. Those inputs are work. The work of people creates value. Some of that value goes back to the people who provide it in the form of salaries and benefits. The rest of it goes to the owners of the companies. There are literally billions of people in the world whose daily work is increasing the value of the stock market. Invent something to sell on the app store? Build a new type of wrench that can be sold to Home Depot and then sold to consumers? Come up with a better way to drain a perirectal abscess or manage diabetes? Some of that work you did will flow into the stock market, increasing its value.
I hope it has become obvious to you why I invest in stocks. Now I have no idea which companies are going to provide the best returns. That's why I just buy them all using low-cost index funds. Yes, I know that Wall Street is working hard to get its cut and that sometimes the system isn't fair and some people even cheat it. But I expect to do well in spite of it.
Yes, I know I have little control over short-term outcomes in the stock market. That's why I don't put the money I need any time soon in there. Yes, I know there are other great investments out there like bonds, real estate, and small businesses. I buy those too.
Yes, there is a risk that the entire financial system and world will melt down in a zombie or nuclear apocalypse. In which case I will have to rely on something besides financial assets to survive. But it seems silly to me to avoid investing in stocks because you think the stock market is just a giant casino with no guarantee that it will go up in the long-term. This is an asset class worthy of inclusion in every portfolio.
What do you think? Why do you think the stock market has “always gone up in the past”? What do you think the likelihood is of it rising in the future? Comment below!
John Burr Williams , in his book “The Theory of Investment Value” describes this concept beautifully as you have. Financial historians say he was the first one to challenge the casino view of the stock market. He says the value of a stock is simply the discounted value of all the companies net cash flow from now until eternity. In one of Buffett’s letters to shareholders, he describes a company as a bond with a rising coupon. We don’t know who fast that coupon will rise, but it is the rising coupon that makes the stock go up. In another interview, Buffett states it is the “retained earnings” of the company that makes the stock go up. The Walmart analogy is timely. I just sat down with a client who told me she wants something less abstract. I told her that the next time she goes by Walmart, drop in and look at all the people buying things. You own that store. It does not get less abstract than that. I went into Walmart the other day to buy a bike helmet. The store was very busy and thus encouraging to the owner of the company (me). Bogle says the financial intermediaries are the croupiers. I am looking forward to the continuing financial education week in November. I always get a book or two out of that week. The advanced reader might want to watch a YouTube video on how to determine the price of a bond. After watching it and doing one bond problem, the reader will have a robust understanding of why stocks go up. It is because the “coupon” of the company rises on average over many companies. Great post Jim! Keep ’em coming. I am very excited about WCI CON 2020. I am using the principles from the happiness literature to enjoy the conference more. That is, enjoying the anticipation of the event, preparing for the event, etc…
Great article. Just a couple questions.
1. How do inflation adjusted returns usually fare when a country enters a hyper inflationary situation?
2. We see in history a country’s greatness can fall and rise. Does the stock market necessarily follow that?
Thank you
Jim another dominating post yet again! I love the reference to Legend of Zelda- I spent a crap load of my time beating that game’s second quest without even dying. Luckily my time at that age was not as valuable as it is now.
As for Paul’s question I am sort of a newbie around here but I believe inflation adjusted returns do poorly in a hyper-inflation situation- and then also taxes hit you more because you are taxed on the nominal (pre-inflation) returns! If you have debt though hyper-inflation would be awesome. For myself with the big doctor house mortgage and still with student loans I wouldn’t mind some hyper-inflation. My asset allocation in my investments is 80% equities so would hyper-inflation won’t be as much as a blow.
As for a country’s “greatness” it looks like on the chart provided South Africa and Australia have had the best equity real returns! I hardly consider these countries as “great” as the US, and South Africa??? The original apartheid government??? I am actually very surprised with that! Seems a country does not have to be geo-politically dominating or “great” to have a good stock market.
1. Owning the means of production helps, but no economy does well in a hyperinflationary situation, so wouldn’t expect stocks in that country to do well during that period. Certainly better than cash or bonds of course.
2. Not enough data to really know, but what we have doesn’t look good. Consider the Russian stock market in 1918…
Great column full of great info financial folks assume is already understood by all. Well, I didn’t understand it until reading your column!
Would love to see u take a company whose stock is in decline and explain how that happens. Thinking of JC Penny and how, if a company doesn’t adapt to change, they may lose value.
Companies go bankrupt all the time and when they do, their stock becomes near worthless. One good reason to avoid individual stock investing.
Here’s one,
Eastman Kodak invented and held the original patents on digital imaging. But they essentially “buried” it because the cash cow profits from film and photographic paper sales were too lucrative. Estimates 30 years ago were that those sales would begin to tail off in the 2010 to 2020 timeframe. Of course it came much quicker and the company was not prepared for the early and rapid change.
Agreed on all counts.
One of the greatest challenges when discussing the stock market with relative newcomers (or even, sadly, those who have been investing for years) is addressing their belief that there is a casino-like aspect that should be “played”. The key, I’ve found, often comes down to the naming conventions; I always refer to “businesses” I own, not “stocks” I own, which clearly differentiates the mindset of owning a company for the long-term versus holding a piece of paper for trading.
Take care,
Ryan
I’m curious how you would interpret the changing demographics of the American population. As you know, the largest generation in American history is now transitioning into retirement and switching from the accumulation to decumulation phase. At the same time the younger generations are saddled with debt their parents and grandparents never had, and will not have the ability to participate strongly in the type of American consumerism that propels our economy. Given that the majority of our economy is consumer-driven, how do we know that we will not experience something similar to Japan, whose economy has been stagnant since 1990? Do we shift away from American stocks and towards world or emerging markets? I am quite concerned about the next 20-30 years. I have a graphic of Japan’s NIKKEI average over the last 80 yrs but can’t figure out how to post
I have thought a lot (too much) about this too. I have read some opinions saying that Japan is an aberration. However, I think that stagnancy is the inevitable conclusion of every market. Exponential growth simply cannot continue forever in any system.
This doesn’t mean I’ve exited the market. I think for most people there aren’t really any better options.
Others have made the argument that Baby Boomers selling off their stocks will cause the market to fall, but that’s very unlikely to happen for at least reasons. First, research by the Bureau of Labor Statistics and others indicates that retirees as a whole don’t really spend down their portfolios very much. Certainly some do, but many others allow their portfolio to continue to grow during retirement. Second, if these retirees did sell some of their stocks, they would presumably do so to buy the stuff that Jim mentioned in the above post, which helps to keep the economy and the stock market doing well.
Vanguard did an analysis of this issue last year and concluded the following:
“The demographic changes occurring in the United States will have noticeable implications for labor markets, public finance, and political developments. However, Vanguard finds no credible evidence that demographic changes alone will negatively affect future stock returns.”
https://vanguardinstitutionalblog.com/2018/03/05/demographics-and-equity-returns-a-far-fetched-horror-story/
Not terribly worried about that. If Americans don’t buy those stocks, lots of non-Americans will buy them from them.
So it just inflation or an overall positive net in buyers coming in? Or a combination? How would you tease the two apart?
Not sure what you’re asking exactly.
So straightforward and so helpful. I invest based on the past 100 years but our insane national debt does make me concerned for the possibility of a “zombie apocalypse” type scenario where there’s a massive collapse of the market and it doesn’t recover. (“Past performance is no guarantee of future success”) Is that a reasonable fear in the next 30 years? I don’t remember you writing a post on the national debt and how that could/should affect one’s investing but that could be interesting/scary. At the end of the day I don’t have a much better option. I know some who buy lots of gold to prepare for such an event but that doesn’t seem like the best course to me.
What I’ve always wondered and don’t understand is how an economy can grow at say 3% per year while its stock market can grow at 10%. Anyone smarter than me figured this out?
The Bogleheads have discussed why this happens. Here’s a relatively new thread on the topic: https://www.bogleheads.org/forum/viewtopic.php?t=281369
Thanks!!
I’m a simple person. I figured that the stock price grew in the positive when someone purchased and in the negative when more people sold stock for lower than the current price. I realized that the stock market was simply a big ponzi scheme if it weren’t for the fact that you could short/sell. Only way for your share to increase in value (if you are simply a buyer/holder for long term) is for other people to buy it at a higher price than for which you purchased it.
Disclosure: I am long stocks. And short. Which ever makes me money.
So why would they pay more? Oh yes, because the business makes more and has become more valuable. I suggest you start over again at the top of the post. It was written for you.
I love the metaphor to “the rake”. A famous Rounder’s quote comes to mind…”In the poker game of life, women are the Rake”…
Not trying to get into a sexist battle here…just bringing up a memorable quote as I think it is fitting. In your article this quote could be changed to “In the poker game of investing, Commisions and Fees are the Rake!”
Good article overall. But you are still killing me with that outdated Bitcoin graph! 😉
There is no such thing as an up-to-date Bitcoin graph.
@ stockguru the stock market may resemble one in the same way that currency does, it is not exactly a Ponzi scheme. The businesses can increase in value by earning and retaining/ investing profits. It is not a zero-sum game. I freely admit that stock prices don’t merely reflect the hard assets owned by their businesses, but it is a concrete way to start illustrating that businesses can add value to themselves when profitable.
And that value doesn’t come from someone paying a higher price for the stock.
Making money, the Legend of Zelda and perirectal abscesses – I feel like you wrote this article with me in mind!
I actually did. I bugged your house. And your office. And the OR.