Why Do Stocks Go Up?

Personal Money Planning |

By Gary Silverman, CFP®

The other day I was asked why stocks go up. The simple answer is because they become more valuable over time. But why? That’s what we’ll talk about today.

While stocks certainly do not always increase in value (exhibit A: 2022), their value (as a whole) does tend to generally increase over time. There are several intertwined reasons.

First, most companies create value. Take a mining company. They take a piece of unsuspecting earth, put holes in it, and remove something valuable. Let’s suppose they’ve unearthed iron. Because iron is more valuable than dirt, the company has now created value where there previously was none or very little.

Another company might buy the iron to produce nails. A lump of iron has value. That same lump made into a nail has more value.

Yet another company will use the nail to make a house. A house has more value than the pieces that make it up.

Notice that in each step a company took something of lesser value and made it more valuable. Assuming they planned correctly (which is easier said than done), it will cost them less money to make an item than what they will earn when they sell it. That profit makes the company more valuable.

Stocks are pieces of company ownership. So, if a company becomes more valuable, the company’s stock shares become more valuable as well.

I know what you’re thinking: If that’s true, how in the world can most stocks go down in value during a year (revisit exhibit A)? That is dependent upon how a company is valued by investors. And while there are several main schools of thought, each person combines their own mix of factors together (even if the only factor is “I feel good about this company”) to come up with what they think is a fair price.

Investors naturally prefer to pay less than the fair price (everyone loves a sale, after all) and sell at greater than a fair price (making money feels good). All these guesses about fair price end up determining where the stock is valued at any point in time.

Humans making guesses (sometimes irrationally) is what causes the price of stocks to go up and down seemingly at random. Most of us (myself included) do not know the true fair value. But, over time, as the company takes something of a particular worth (dirt) and makes something of value (a nail) and does so cheaper than what they can sell the nail for—even the naysayers will realize that the company became more valuable.

And that is what over time makes stock prices go up.

May Ukraine Be Free