If you invest in the stock market, you are very likely to generate a positive return over the long run. Why does that happen, why do stocks increase in value? There are no guarantees in life except death and taxes, but we can say with a certain degree of confidence that the market will generate a positive return over the next 10, 20, 50 years.
Let’s take a look at S&P 500 over the last 20 years. We don’t want to look at S&P itself but an easy to invest asset that our readers can easily purchase that mimics the S&P and see how it has performed. We will look at S&P 500 ETF, specifically SPY.
If you were to invest $10,000 in SPY on December 31, 1993, by the end of 2020, you would have $132,497. The return does not include any fees that SPY operators would charge, but those are insignificant, and we can ignore them for this illustration.
The point is, SPY has returned over 10% CAGR (Compound Annual Growth Rate). Compare that with any of your saving accounts. So why is that, and why are we confident this will keep happening in the future?
Why do stocks increase in value?
Stock prices are a function of two things. One, the underlying value of a business, and two, the price multiple that the market is willing to pay for that stock.
The value of the business goes up
First, let’s revisit the definition of a stock. Stock is simply a piece of a company. If the value of a company goes up, then its pieces go up in value as well.
The price of a stock goes up unrelated to its value
Stocks are traded on the market, where they are bought and sold every day. This everyday trading creates supply and demand for certain stocks that drive the price either up or down. Note that the price of the stock does not necessarily reflect the “value” of a company. When that happens, we often hear analysts say a particular company is under or overvalued.
What drives the value of a business?
Businesses go up in value when they grow. Acquiring more customers, increasing sales that result in higher profitability is the main reason for the company to go up in value. When companies go up in value, then typically their stocks go up in value, although typically after some time.
What drives the price of a stock?
Prices can be disconnected from value. In fact, we can argue that most of the time, they are disconnected. Nobody can, with absolute certainty, calculate the actual value of a business. It happens all the time and is the primary reason for stock crashes, like in 2000 where prices for technology stocks were so absurdly high that the only way for these prices to catch up with companies’ actual values was to go way down.
Stock prices are driven by multiple factors that can be all summarized into “optimism” or “bullishness” and “pessimism” or “bearishness.” Let’s say buyers are optimistic about a particular stock. Maybe because of the good news shared on social media and they flock to the market to buy more of that stock without checking the “true” underlying value. That will drive the demand, and without additional supply, the price will go up.
Price is, therefore, a function of Company Value plus a multiple that people are willing to pay for that company. Value is driven by facts, and the multiple is driven by facts plus opinions plus emotions. We cannot control the multiple as individual investors, but we can be vigilant about checking with the company’s value and making investment decisions accordingly.
Why are we optimistic the stock market will continue to deliver positive returns?
Generally, we believe there will always be businesses created that will produce positive value for the economy. These businesses will deliver growth to their investors. The 500 biggest ones will always be part of S&P500, and as long as the North American economy keeps producing and consuming, we should experience growth.
However, that does not mean we will all make money all of the time.
Innovation as a result of necessity
With increasing global competition and various market forces at play, innovation is a necessity. And in turn, innovation will drive growth. It is not to say that everybody will go unscathed. Innovation will do damage along the way. Companies and even industries will collapse, jobs will be lost or moved to cheaper markets. But in aggregate, we will be better off. New, more efficient companies will create value, create jobs, and become even better investments than old companies once were.
Remember that the stock market is a market of stocks
It is important to remember that the stock market is a market of individual stocks. That means that what S&P 500 is doing is not reflective of individual investments. There will always be overvalued or undervalued stocks at any point in time, even if the whole market is considered over or undervalued.
There will always be bargains to be found and sound investments to be made!