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Why stocks increase in value over the long term

By David Luhman on Sun, 05/10/2009 - 00:49

Why stocks increase in value over the long term

Why stocks make money

Here's another angle on my contention that stocks represent more than scraps of paper. When you buy a stock, you're buying part of a company.

And everyone in this company is, for the most part, actively working to increase the value of your slice of the company. And this, I think, is one of the main reasons why stocks have outperformed bonds over time.

Stock equity compared with home equity

Think about it this way. When you buy a home, you put up some of your own money and you borrow the rest. Then you spend a lot of time trying to increase the value of your home's equity.

You add improvements, fix up the inside, and make a lot of noise if someone tries to put a toxic waste dump in your backyard. You know that if something bad happens to the value of your home, you as the owner are going to eat the loss. The mortgage banker isn't going to decrease your mortgage just because something bad happened in your neighborhood.

So you, as an owner, spend a lot of time and brain power trying to improve the value of your home. At the same time, you're doing all you can to cheat your mortgage banker.

Bond (mortgage) holders enjoy little upside

OK, maybe "cheat" is the wrong word, but what are you going to do the first time mortgage rates drop two points below your rate? You're going to refinance the mortgage and get out of your old, expensive mortgage.

Of course you're not really cheating anyone because the mortgage banker knows what's going on, but I hope you see what I'm getting at. Bonds and mortgages are basically passive debt investments, while stocks and home ownership are active equity investments.

As long as you've got company management who own a lot of stock, and thus have their interests aligned with stockholders, you should have a management team that is trying to protect your investment in the company's stock.

How company management cheats bondholders

On the other hand, that same management is trying to find ways to cheat the company's bondholders. But in this case, I don't think "cheat" is an exaggeration.

In the 1980s debt holders really were cheated by managers who were looking to help the stockholders. The leveraged buyout of RJR Nabisco is a good example.

By taking on additional debt, RJR Nabisco's managers could buy back the company's stock and gain control of the firm. Of course, this would hurt the current bondholders who would see their investment grade debt be downgraded to junk bond status.

Bondholders know that managers often try to cheat them, so the bondholders try to come up with bond covenants that will prevent this. But as the RJR Nabisco bondholders found out, words on a piece of paper sometimes are little defense against managers who are actively trying to cheat you.

Stocks beat inflation

Finally, the threat of inflation is another reason to believe that over the long run, stock investments are better than bond investments. As I discuss in my tape on bond investing, inflation is the number one threat facing a bond investor.

When you buy a bond, you exchange money today for a fixed amount of money tomorrow. But if the money you receive tomorrow has less value because of inflation, you'll get burned.

But stocks don't face as big of a threat from inflation. When you buy a stock you're still exchanging money today for a stream of money in the future, but there's a key difference. The stream of money you'll receive in the future has the potential to grow.

Assume you buy stock in an oil company, and then a few months later the price of all items, including oil, shoots up. As the price of oil increases, these increases should eventually benefit you as the oil company's earnings and dividends are increased.

This is different from the bondholder whose interest payments won't be increased, unless he happens to hold inflation-indexed bonds.

I hope you have at least some money in stocks

So I hope I've convinced you to put at least some of your money into stocks because of their long-term potential for higher returns and because of their inflation protection. But remember to keep your money in a variety of assets. See my tapes on retirement planning and mutual funds for more help with asset allocation.

In spite of the need for diversification, it seems like people are becoming too mesmerized with the recent good performance of stocks.

I'm not sure where the American stock market is going, but I can't help but get a little cautious. The American stock market of the late 1990s is beginning to look a little like the Japanese stock market of the late 1980s.

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