Thursday, November 22, 2007

What Makes the Stock Market Go Up?

Over the last 100 years, the Dow Jones Industrial Average has gone from about 65 to 13,000, a factor of 200. But this is only about half of the return because it doesn't include dividends. So you can multiply this by another large factor to get the full returns. Of course stocks have had some major blips in the last 100 years, but this represents a relentless rise in stock prices. Even factoring out inflation, stocks have made an impressive long-term run. In the short term stocks rise because there are more buyers than sellers, and when demand outpaces supply, prices must go up.

Over the long term it seems like the stock market creates wealth out of nothing. Science teaches us the law of conservation of energy, we often hear that there is no free lunch, and we talk of zero-sum games, but the stock market doesn’t seem to be bound by any such law. Over the long term, almost everybody who stays in the game seems to win.

What makes stock prices rise over the long term? The short answer is innovation and hard work. The increasing number of people is a factor too, but the main driver of stock market prices is the continuous improvements in our lives due to better ways of doing things, better tools, and better toys. When a company hits the market with a better product at a lower price, the average person’s life improves a little, and this ultimately translates into more overall value in the stock market.

If you still believe in continued innovation in our society, then you should be comfortable with the long-term prospects of stocks as a whole.

See more on this in the next post.

1 comment:

  1. David asked "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?"

    Good question. I think I'll clarify this in tomorrow's post. For now, the short answer is no. Inflation is a measure of what things cost, not a measure of what we all have. I'll draft something more understandable than this.