Friday, November 23, 2007

More on Why Stock Prices Rise

In my last post, I discussed how stock price increases over the long term are possible. A reader, Steve, asks “If the value of stocks keeps on rising at a greater rate than inflation, wouldn't that mean that less and less people could buy stocks in the future due to lack of necessary funds?” This is a good question that points to the seeming paradox of the stock market creating value out of nothing.

Let’s start with understanding inflation. Inflation is a measure of the increase in prices of the things we buy, like food, gas, and clothes. At the beginning of the year, a particular basket of items is selected as the typical things that people need, and the price of this basket of items is added up over the course of the year to measure the cost of living. If inflation is 3% one year, then the cost of this basket of items has risen 3%. Another way to view this is that the things we buy have constant value, and the value of money has dropped.

Now, just because inflation is 3% doesn’t mean that we all have 3% more income to spend. Some of us will have more than 3% more income over the course of the year, and some less. The fact that over the long term the stock market rises faster than inflation means that our overall buying power rises faster than inflation. So the question becomes, how is it that we can afford to buy more and better stuff today than we could 50 or 100 years ago?

The answer is that we can produce most items like food and clothing with much less human effort than was possible in the past. Better processes make it possible to produce goods with less effort, which frees people up to do other things and make other goods. This ability to do more with less means that the sum total of all the things we can produce rises over the years, and this is reflected in stock market prices.

So, stock market prices cannot indefinitely run away from the amount of money people have to spend. In fact, over the long term, stock market prices exactly reflect the total value of all the goods and services we produce. Over the short term, the stock market can fluctuate wildly, but over the long term, it can’t get away from the sum total of the value of our efforts.

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