Why investing in stocks could be a good place to start for you

Introduction

Last week, we saw how painful inflation is for our savings.

As we have no control over the amount of inflation we have to deal with, we should look at what we can do to protect our purchasing power.

Investing, in general, can be a great remedy.

Why?

Because while inflation is slowly burning away our purchasing power, investing can add money back to our stack by giving us “returns”.

Let’s have a closer look.

Before we start

Today, we’re talking about investing again. With it, has to come a mandatory disclaimer. As always, the information I provide is sourced from both reputable sources and my own experiences. I intend to inform you about the financial world and help you make better decisions, but none of the information in this email should be taken as financial advice or advice to purchase certain financial products. See our full disclaimer here.

What is investing?

In very simple terms, investing is:

Spending (allocating) money, with the expectation to make more of it.

A bit more formal now:

“Investing is the act of allocating resources, usually money, with the expectation of generating an income or a profit. You can invest in endeavors, such as using money to start a business, or in assets, such as purchasing real estate in the hope of reselling it later at a higher price.”

It is, of course, not a given that you will make more money. Investing has to have a risk of not making more of the money you invest, or downright losing your investment.

That’s the price you pay for the chance of making more.

Not all investments are the same, however.

Giving your hard-earned savings to two guys in a garage to launch their new business, which is “like Tinder for ducks”, might be a bit more risky, than let’s say loaning it out to the Dutch government (in the form of bonds).

All investments, from crypto to real estate to the stock market, have different characteristics in terms of risk (and reward!).

In my opinion, stocks could be a good place to start for young professionals.

What are stocks?

The ownership of most companies is divided into smaller pieces called “shares”.

Just as a beach consists of many individual grains of sand, most companies’ ownership is made up of a lot of individual shares.

In the past, these were actually physical pieces of paper stating the name of the company and the name of the person that bought the share, the shareholder.

Shareholder companies have been around for a very long time and actually date back to ancient Rome.

The first actual stock market was created here in Amsterdam in the seventeenth century, when people could trade shares of the East and West India Company (VOC & WIC), in 1602 and 1621 respectively.

If you're interested in reading more about the first stock exchange, you can check out: https://www.worldsfirststockexchange.com

Nowadays, all this information is digitized and being tracked by an exchange.

On this exchange, people buy and sell stocks to each other.

As an individual, you can’t directly buy stocks on an exchange.

You need to do this through a broker. Examples of well known brokers in the Netherlands are Saxo, DeGiro, BUX Zero and eTorro, but it’s also possible to invest with your bank, such as ING or ABN AMRO.

We’ll talk about the how of investing soon!

Okay, so why could stocks be a good place to start?

We’ve already seen there are a lot of different things to invest in. These ‘things’ are also known as asset classes.

There is equity (stocks), bonds (loans to government / business), gold, real estate, crypto currencies and much more.

So why would the young professional, with a long-term view, invest in the stock market?

​According to some experts, the stock markets are “the greatest compounder of wealth the world has ever seen.”

But, to become a long-term investor, it is important to understand why.

The stock market is the average of actual companies, that are part of the real economy.

By buying shares. you are investing in a business, that does what companies do: creating value and receive money in return.

So owning a stock is owning a part of the future cash flows (earnings) of a business.

Stocks increase in value because companies generate a profit and management of the company uses this profit to improve the value for shareholders. They can either:

1. Reinvest it back into the business to grow it even further (investing in company itself or by acquiring other businesses).

2. Distribute the part of the profit back to shareholders (paying out “dividend”).

Earnings growth

If you take the average of all companies in the U.S. since 1871, their earnings have grown 3,99% annually (Shiller, 2016, pp. 1–3).

Some grew a lot faster, some a lot slower, some went bankrupt along the way, but 3,99% is the average. So this is the first way companies increase in value.

Dividend

The second way we get returns from investing in companies is dividend.

As co-owners, we deserve a part of the profits the company makes.

If we take the same average of all companies since 1871, we would receive another 4,55% of return in terms of dividend.

So our total return on average is 3,99+4,55 = 8,54% per year.

Important to know is that the management of a company always has a choice on what to do with the profits and how to best create value for shareholders.

For a fast growing company, that might be to reinvest all the profits back into the company to further accelerate that growth.

For a slower growing company, growth opportunities might be more limited. It can therefore be better to keep the business growing organically and give the rest of the profits back to the shareholders via dividend.

How much is a company worth?

So, how much is a company worth? What is a good investment?

Stanhope says: “The value of any company should theoretically be the combined value of 1) its existing business persisting into the future, and 2) a speculative component that represents the market’s guesstimate of the present value of future growth.”.

The simplest way to measure a companies valuation is looking at how much do people pay for €1 of earnings.

This metric is known as ‘Price-to-Earnings’, or PE.

In 1871, people were willing to pay about 11,10$ for every $ of earnings of a company. Over time, this value has gone up to about 18, but it averages on 15.

Price-to-Earning matters, because it helps investors choose between possible companies to invest in (among many other factors).

This is an increase of about 0,47% each year, know as the multiple expansion.

What that means is that, over time, investors are willing to pay about 0,47% more for the same amount of earnings.

This will also increase the value of our shares over time:

Adding this to our 8,54% creates a nice, 9,01% return per year on average for U.S. companies since 1871.

We can now conclude that markets go up over time, because the average company grows its earnings over the very long term, dividends are paid and markets value the stream of earnings and dividend differently over time.

You might now still wonder, but why do the earnings of companies go up over the long term?

Why do companies on average keep growing and making more money?

(It's a whole other question if ever-increasing growth is sustainable, that's something we'll dive into later 😉).

Increasing earnings

There are three factors that make company earnings go up (on general, in the long term).

Inflation

The first is one you’re quite familiar with now: inflation.

The increase of costs will be paid by us, the consumers.

So, the prices of companies will keep on steadily rising, with inflation.

Productivity

The second factor is productivity.

Thanks to technology, humans get increasingly better at what they do (Neumann, 2019).

There is either value creation (something completely new as the steam engine that started the industrial revolution, or let’s say, the internet) or efficiency gains that happen incrementally.

Productivity, defined as real GDP per capita, as been steadily increasing with about 2% since 1947 (Dalio, 2017).

Inflation and productivity also play well together; inflation drives up the costs, making humans find innovative ways to do more with less: to be more productive.

Demographics

The last force that causes earnings to grow is population growth.

There are increasingly more people in the world, who also want to buy products and use services.

This will further increase the earnings of companies.

Combining all we’ve learned

Company earnings tend to go up over time, caused by the three factors described above.

Now we understand why the stock market in general tends to go up over time.

Note that this certainly isn’t true for any one individual company, but it is for the whole market, the average of all companies as a whole.

Capitalism, with all its imperfections, works.

Businesses generate profits.

The successful ones employee people. These employees earn salaries, that they spend in their lives.

Now we just have to hope that these companies will invest their earnings in to new innovations, that push human productivity up for decades to come.

The proof is in the pudding

The chart below shows a large collection of American companies (the Dow Jones Industrial Average) over a very long period of time. Next to it are important events and on the bottom American presidents.

Note: this is a logarithmic scale, so the chart is actually going sky-high! We’re covering 30 to 30.000 here, so an increase of about x1000 over those 120 years.

You can see that the market tends to go up over time.

But also, that it can take a long time to recover. This is why a long-term vision and patience are so important.

Conclusion

Stocks could be a great place to start for the beginning investor with a long-term view, because you directly buy into real companies in the real economy.

These companies in general, in the long term, tend to grow their earnings and thus the value of your investment (the stock price).

Next week, we’ll talk more about how to invest.

As always, let me know below how this one was!

And spread the word <3