June 27, 2019Individual Investment Management

Why DO Stock Values Rise?

The assertion that stocks are excellent long-term investments is not held by all investors (thank you, 2008!). There are, however, good reasons why values of companies generally rise over time.  

Read on...

Historical Returns:
According to Credit Suisse (CS) long term track records of investments around the world between 1968-2017 annualized are as follows*:
   Japan:  Stocks = 4.8%, Bonds = 3.7%
   UK:  Stocks = 6.4%, Bonds = 3.8%
   USA:  Stocks = 5.7%, Bonds = 3.7%
   EU:  Stocks = 6.3%, Bonds = 5.1%       
      *Returns after inflation. (Note: Returns per country here!)
        *Source: CS Global Investment Returns Yearbook 2018. 

Understanding the Math:
Shares of stock are simply the present value (PV) of a company's future earnings. Also note that a dollar is worth more today in-hand than it is tomorrow (due to your ability to invest that dollar now and not later.)  With that said, imagine a hypothetical company and its earnings.  If we were reasonably confident in the cash flows of the company, how could we value its share price?  If we used a discount rate of 10% to value this company, we would arrive at the following below.

Takeaways...
Modern companies are more complex than our simple example above, but the point is to understand why (over time) company share values tend to rise.  The discounting mechanism that investors use to discount risk and value companies is important because investors must be rewarded for taking risk.  Bad companies will always fail, but by investing in a broad swath of companies (a.k.a, diversification), you will ensure that your investment will include the outsized gains of the companies that do succeed.