Preface
Historically, stocks delivered superior returns over any other asset class. Any financial adviser will advise you to allocate a significant portion of your money into stocks citing the aforesaid statistic. But how and why? Why stocks as an asset class performed well over the long term than any other investment type? What is the reason for stocks to fare well than any other asset? Do stock brokers and traders make money in the stock market by rigging prices? No, not at all.
You can invest money in the stock markets through mutual funds or money managers. Financial advisers offer you advice for a fee. As far as your money is concerned, it is your own hard earned money. You know how hard you sweated it out. Hence it is better to take the time and effort to manage your money yourself. Better eat what you cook. Had those advisers heeded to their own tips and had those stock tips been correct, they should have been the richest by now. Hence it is in your best interests to know how stocks remained historically as the best investment asset class, and why it would remain so in the future.
If stock market experts were so expert, they would be buying stock, not selling advice.
-Norman Ralph Augustine
Why Are Stocks Good Investments?
Let me assume you are a novice in stocks and businesses. To understand the reason how and why stocks remained the best investment class historically, first of all you should understand the basics of business, finance, investing, company, stock, and stock market. Enough information is available in the public domain about these jargons and about the business affairs of all companies. Only you need to find the time and have a will to seek and understand all the related information. Let’s have a sneak peek into the very basics and then analyze the answer for our question.
Business
In simple words, the definition of a business is that it is a mercantile or entrepreneurial activity of making and selling goods or buying and selling goods or providing services in exchange for money. The positive difference between the income and expenditure of this business measured over a period of time (usually a year) is profit. In other words, profit is the money left back after all the expenses that are associated with the operation of a business have been paid. Businessmen run businesses for this profit, to make money. Businesses are money making machines. Entrepreneurship is a mindset. Not everyone of us is blessed with it!
Company
A company is an entity or an organization that performs a business. There are different types of ownerships of companies. They are proprietorships, partnerships, limited liability companies (private limited), and corporations (public limited). Out of these, we are interested only about corporations (public limited companies) whose shares are listed and traded in stock exchanges. We are small investors without any good business plan or entrepreneurial mindset and without any access to prerequisite information. Thus investing in the first three types of ownerships is ruled out for us. Let’s be content with buying shares in corporations. A known devil is better than an unknown angel!
Stock or Share
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A stock or a share is a fractional ownership in a company. Let me illustrate it with a simple example.
Assume that you are starting a company that needs a capital of 100 bucks. However, you have only 40 bucks in your hand now. So you are short of 60 bucks. Instead of borrowing and paying interest, you make an initial public offer (IPO). You issue 60 shares to the public and collect 60 bucks from them. So all the investors in your company are co-owners. You are the major share holder. The rest of the persons are minor share holders. So, all of the shareholders are owners of the company. They are entitled to receive their share of profit as dividends. The liability of the owners is limited to the capital they have invested. They do not have any liability to the debt made by the company. It is just as simple as that. Many little drops of water make the mighty ocean!
When buying shares, ask yourself, would you buy the whole company?
-Rene Rivkin
Stock Exchange
A stock exchange is a marketplace. It is where shares of different companies are auctioned and traded through dealers called stock brokers. Apart from shares, securities (financial instruments) that include bonds, debentures, mutual fund units, currencies, derivates etc., are also traded. Essentially, a stock exchange is a marketplace of financial instruments. Your view of a stock exchange as a giant casino now should have changed. A stock exchange is a place where fractional ownerships of companies, businesses, are sold!
One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.
-William Feather
Why Stocks Give Superior Returns?
Now coming to our pertinent question, “why do stocks give superior returns over time?”
With companies making profits year after year, they have two options. Either reward the shareholders by distributing the profits as dividends or retain the profits. Companies that retain profits invest that money back into their businesses to aid further growth. Money makes money. By compounding over a long term in a good business, a small seed capital thus gets snowballed into a huge fortune! That is the power of compounding! You start with pennies and end up with billions! The more the time given to compound money in good businesses, the more the returns.
Furthermore, profits are taxed at the hands of a company. If the profit is distributed among the shareholders as dividend, it is taxed again either before distribution or at the hands of the shareholder. That is double taxation of a single profit. However, the profit can be taxed only once if the profit is retained with the company itself. Such retained profit is at the mercy of a company for further capital investment and expansion of the company’s business. If a company avoids dividend and uses the profit for further growth, you kill two birds in one stone. Avoid double taxation and rest the money with professionals for further compounding.
Time is money
So, for an investor, time can be equated to money. Time is the friend of a patient investor in a good business. Compounding is the short and simple way to riches. The magic of compounding helps build a mass fortune for the patient investor over a long time in a good business. On your part, all you need to do is to identify an ideal business with enduring competitive advantage, a business within your circle of competence, make sure to avoid these investment mistakes, buy it when the time is favorable at a price much lower than its value, and stay invested as long as you can. Let the power of compounding do the rest and make you rich over the long term. Businessmen chase money. Let those who preserve the capital and deploy it sparingly multiply the money for you.
Bottom line
If the underlying business of a company prospers, the stock price of that company should reflect the underlying value and the prosperity of that business. As a result of compounding, the value of a share increases over time. The price follows suit. That is why Benjamin Graham, the father of value investing and mentor of Warren Buffett, the successful investor of all times, called stock markets a weighing machine over the long term. So, compounding of money is the underlying reason why stocks remained historically the best investment asset class.
If a business does well, the stock eventually follows.
-Warren Buffett
Short and sweet. You made it a blog post to answer my question. Thank you sir. I was more interested in the yearly highs and lows. Now my perception has changed altogether.
But you have to be careful. Only if the underlying business thrives, its stock would thrive. Ultimately your success depends on how good the business you pick is.