What is the stock market?
The stock market is where you buy and sell shares in companies. We’re surrounded by brands that make up the stock market – from Apple to Zara – your day will be spent interacting with many of them. Investing in the stock market means you’re literally buying a slice of one or many of these firms.
Why invest in the stock market?
You should consider investing in the stock market because historically it has generated a good return on your money. The chart below shows the US stock market over the last 50 years. Had you invested in it 50 years ago, you would now have made 21 times your money.
Why does the stock market go up?
The stock market is made up of shares of lots of companies. And over the long-term the price of any individual share is driven by that company’s worth. What it’s worth is driven by how much money it makes in profit.
So, a company’s profit is what drives its worth, and what in turn drives its share price and what in turn drives the stock market.
Why do company profits go up?
Because when a company makes money, it reinvests those profits back into the business (to make more and sell more) and it grows. Let’s look at the world’s most valuable company, Apple.
Apple invested the profits from its first computer back into the business – then it launched the iMac, later the iPhone, then the iPad and more recently the Apple Watch. Apple continually reinvests its profits, develops new products and grows… and so has its share price over time.
Not every business is as successful as Apple but to help illustrate why the stock market grows it can be helpful to think about what happens in the businesses themselves. Companies in general expect about a 10% return on investment (ROI), some get more, some get less (please note we are using generalisations here to make the point, and these returns are not reflective of all businesses). This ‘average’ company would expect to pay out about 3% per annum in dividends and reinvest 7% of the profits back into the business, again this varies from company to company.
If company profits rise at 7% (10% average ROI minus 3% paid out in dividends), then company value should rise at 7%, its share price should rise at 7% and the stock market should rise at 7%. And that is what has happened historically.
See the graph below, the red line shows you 7% annual growth over the last 50 years. And with this you see the actual growth of the Dow Jones index (an index of 30 significant stocks traded on the NY Stock Exchange and Nasdaq which is often seen as a proxy for the broader US economy) in grey. They’re similar, aren’t they?
The stock market has historically gone up because companies have historically grown their profits. As an investor and owner in these companies, you profit when these companies increase their profits.
PS: what about cash?
Over a 40-year period by investing in the stock market you would have made 4 times more money than you would if you kept it in a savings account*.
Imagine what you could do with this extra money in the long-term…
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Did you know?
- Stocks, shares, equities are all different words for the same thing.
- You can make money from shares in two ways:
- If the company grows and becomes more valuable, then the share you own is worth more.
- Some shares pay you part of the company’s profits each year, these are called dividends.
*Source: Barclays Equity Gilt Study.