Why do we invest in the stock market anyway?
2018 was a challenging year for the financial markets, to say the least. When markets perform poorly and investment portfolio values drop it is only natural to ask, “Why do we invest in the stock markets at all?” After all, there are safe investments that will give you a guaranteed return without any ups and downs. The short answer, because stock markets go up over time and this builds wealth. Why do they go up? In the short-term, markets go up and down for any number of reasons. A political event, a terrible storm, an act of terrorism, etc. Over the long-term, there are fundamental reasons why the stock market goes up over time. Here are three:
Risk and Inflation
To begin, we have to have at least a cursory understanding of the role of the stock market in our economy and to a larger extent our society. With the pervasiveness of financial news today it is easy to forget that fundamentally the stock market, like any other market, is a place to exchange and trade things. In this case, stock, which represents a small ownership stake in a business. These businesses can be enormous companies like Apple or Microsoft or even small to medium-sized businesses depending on the stock exchange you consider. These are the businesses where you and I spend our money. We buy things and pay for services and money is exchanged. On a grand scale, this activity represents our economy. For this reason, the stock market is often a good way to gauge the strength or weakness of our economy at any particular time. It’s also the reason that stock prices go up when economies are strong. Businesses make more money and more profits and share values go up as a result.
The next concept to consider is inflation. In simplest terms, inflation means rising prices. When economies heat up and the demand for goods and services is on the rise, prices will rise to account for this increased demand. In the short term, this is good for business, but in the long term, inflation is not good for the economy. Your cash can’t buy as much as it previously could. This is a very important concept. Cash does not maintain purchasing power. This is the reason we invest our money and not simply stash it away in a safety deposit box. We want to maintain pace with inflation and the investment return is the way to achieve this objective. Now, if this was your only objective, a rate of return that was equal to the rate of inflation would accomplish this goal, without accounting for taxes. Let’s assume inflation has hovered around 2% per year. This means, $100 worth of goods and services today would require $102 for the same goods and services next year. So, if you don’t want to spend your $100 today and want to make sure you don’t lose any purchasing power you’d have to find an investment that pays an interest rate of at least 2% this year to accomplish this objective. So far so good. Most savings accounts and GIC’s would be enough to accomplish this objective. Easy, no risk and done. So what’s the problem? Well, what if you wanted more than just to maintain the purchasing power of your money? What if you wanted your money to grow? Therein lies the rub. When investing for the long term, most people want and actually, need, their money to grow more than just at the pace of inflation or there simply won’t be enough. And, when investing for growth, a savings account and/or GIC simply will not provide a rate of return that allows for this. The stock market does. It does because when money is invested it demands a premium for risk. This risk premium is available in the stock market at a price. That price is volatility or risk. In the short term, you simply don’t know what you’re going to get. The interesting thing is, however, like most things in life, over time the stock market tends toward the average. This means the historical returns offered by the stock market include the historical rate of inflation plus your risk premium. This risk premium is tied to the share price of the companies that make up the stock market and the share price is linked to the profitability of the company. As long as we have people to consume, we will have companies offering the goods and services and making a profit. And so on, and so on…
In 1980, the population in the United States of America was about 225 million. In 2017, it was just over 325 million. More people means more consumers and more consumers means a greater demand for goods and services. Let’s consider an example. Apple is one of the biggest and most successful companies in history. It sells iPhones among other things. Apple makes money by selling new iPhones to the same customers but also by selling iPhones to brand new customers. More people means more potential iPhone sales and more iPhone sales means more profit. More profit means higher share prices, and so on. You get the idea!
Innovation and Technology
Lastly, we get better at doing things. I’m sure you can make the argument that technology has not necessarily improved our lives. In most cases, I’d tend to agree. However, when it comes to business, technology makes companies more profitable. I can use the example of my very own company, TAXplan to illustrate this concept. Ten years ago, most of our valued clients would either come into the office to drop off their tax documents at tax time or we would drive out to see them in order to collect the documents. Online technology has changed this. We now have the ability to collect documents from our clients securely online without the need for a physical office location or transportation costs. We can interact wholly online. This reduces overhead costs and increases profitability. Although TAXplan is not a publicly traded company, you can see the link between innovation, technology and profitability and share price. Companies use technology to improve efficiencies and are more profitable as a result. Over time this leads to increased share prices.
There you go, three reasons why the stock market goes up over time and the reason we invest in the stock market at all. Keep these reasons in mind the next time you turn to the financial news and the announcer is spouting that days’ doomsday stock market events. Remember, over the long term, markets go up!