Why Do Stocks Go Up in Value?

by: J. Patrick Collins, CFP® , EA

Over the last two hundred years participating in the equity markets have been one of the best investments one could make.  Just look at the statistics that represent the real return (return after inflation) of the US equity market (1).:

Long Term        1802-2003                        6.8%

Sub-periods     1802-1870                        7.0%

                            1871-1925                        6.6%

                            1926-2003                        6.8%

What can we conclude from these numbers?  The equity market, as a whole, follows a very predictable pattern, when viewed over a long period of time.  Compare this perspective to what many media and financial experts would have you believe.  How many times have you turned on the television only to hear news of the stock market “plummeting” or “exploding”?  While this may be true from day to day, it is very evident that the market returns a very specific margin over inflation, when viewing longer periods. 

So why have stocks continued to go up in value for the past two hundred years?   The answer is very simple:  With capitalism, there is a positive return on investment.  Capital markets create wealth, by taking things like natural resources, financial assets, and intellectual capital and producing something greater than the sum of its parts.  For example, it may cost a company $1 to produce a widget which they can turn around and sell for $2.  That company has produced a profit of $1 for its owner(s).  Investors willing to buy that company’s stock will set a price that is in direct relation to both how much profit they will earn and the amount of risk associated with earning that profit.  For example, let’s assume I offered you the following two opportunities:

• Invest $1,000 in Investment A.  Investment A is expected to return $200 a year for its investors, with a 5% chance of losing all of your investment.

• Invest $1,000 in Investment B.  Investment B is expected to return $200 a year for its investors, with a 40% chance of losing all of your investment.

It should be obvious to everyone that Investment A is the better choice because of the lower chance of losing your money.  So how could Investment B attract investors?  By promising a higher expected return on investment.  This simple concept is why riskier investments generally have higher expected returns and the basics on how the capital

markets work.  This is the precise reason why stocks have outperformed bonds over long periods of time:  there is a higher degree of risk for equity investments, therefore equities must offer higher potential returns in order to attract investors.  This process of rewarding investors is not arbitrary; it is extremely systematic, evidenced by the real returns (return after inflation) of equities over various time periods shown above.   

Because capitalism and free markets create a positive return on investment, the best way to participate is to make sure a portion of your investment resources is allocated to the foundation of capital markets:  equity ownership.

(1) Stocks for the Long Run and Future of Investing, written by Jeremy J. Siegel

The information in this article is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, and does not purport to be complete and is not intended as the primary basis for financial planning or investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.