Where do stockmarket returns come from?

2019 was another stand-out year for stockmarket returns around the world.

The chart below is in $ terms so the percentages in £ sterling terms will be slightly different but you get the picture:

2019 ACs

Source: www.visualcapitalist.com

Results like this will, for many people, prompt the thought that it’s all too good to be true and what goes up must go down.

It’s certainly possible that stockmarkets will crash this year. But that’s possible any year. A stockmarket crash is always coming…but that’s no reason not to play this wonderful game where the odds are stacked in your favour over the long term.

Here’s the issue: there are always plenty of forecasters of doom on hand to tell you that the gains are not real and markets are being pumped up artificially as a result of some dark conspiracy by Central Banks / Governments / etc and will soon come crashing back down.

It’s certainly true that governments have held down interest rates and that’s lifted all asset prices but that’s no secret. If you read it on The Internet, then it’s already priced in.

People invent stories to try to make sense of the world. These after-the-fact explanations are comforting to our monkey brains. The demand for market forecasts exists so people make up stories to meet it.

It’s strange but the bear case always sounds smarter. In contrast, the optimists sound a bit naive.  Yet, look at what has already happened. Look how far the human race has come and how unlikely that would have seemed 50,000 years ago. Homo Sapiens nearly went extinct during the ice ages. Apparently, at one point we were down to a few thousand people clinging on to the southern tip of Africa surviving on worms and shellfish. I’m told the food in the bars and restaurants of Cape Town is much better these days.

We now live in a world of affluence unimaginable to our ancestors. The agricultural revolution happened.  That was highly improbable. The only thing more unlikely than that was the industrial revolution.  And then the information technology revolution…all of which means we’re living through the greatest period in human history. All insanely unlikely and impossible to predict in advance, all inevitable with hindsight.

The story of the stockmarket is the story of human progress.  There is a good reason why the market always trends upwards.  Yes, its two steps forward and then one step backwards. No, there are no guarantees as to what will happen in the future. But, with perspective, the progress is obviously much more forward than backwards.

If at any level (conscious or sub-conscious) you think of the stockmarket as a casino, scam or an evil tool of capitalism, you won’t play this game where the odds are stacked in your favour. That’s a form of self-sabotage.  So let’s go back to basics and think about where equity returns come from.

Imagine you own shares in a company. Contrary to popular opinion, this is NOT like gambling in a casino.  No, you are a part-owner of the business.  You become a part-owner of all the assets (factories, warehouses, forklift trucks, productions lines, raw materials etc etc) of the business.

Factory
This is what you own when you own shares in the stockmarket

You get your share of all dividends paid by the company. You get a vote at shareholder meetings of the company.  If the company gets sold (taken over) you get your share of the sale proceeds. When you buy a share, you have limited downside (you can’t lose more than you put in) but unlimited upside.

And when you buy a stockmarket fund, you are buying a basket of shares.  With a global equities tracker fund, you own all of the biggest, strongest companies in the world. Regardless of which ones do best, you are on the winning team.

Thanks to technological progress, companies get better and better at making stuff each year.  Competition forces them to improve. Free market capitalism means that different firms are competing with each other to best serve the customer and give them what they want.

And when I say free-market capitalism, I mean regulated capitalism with a government that maintains an independent legal system, promotes competition, breaks up (or regulates) monopolies, provides a public health service and a welfare safety net.

Yes I know that sometimes people want and buy things that are bad for them. Yes I know that companies often try to screw their customers put their prices up.  That’s their job. It’s our job as customers to shop around, make mindful spending decisions and get the best value. Companies are not your friends nor your enemies. It’s just business.

In the chart above, we are talking about total returns. There are 2 elements to the return that you get from equities (aka shares, stocks) or from investment property. Let’s start with property as that’s easier to visualise. So…if you own a Buy To Let flat or rental apartment, where do the returns come from?

Well firstly there is the income. This is the rent paid by the tenant.  If you buy a flat for £200,000 and rent it out for £6,000 per year in rent, then you are getting a 3% rental yield.

Then secondly there is the capital gain.  Let’s imagine that you put the rent up most years either in line with inflation or maybe inflation plus a bit. If the income from the flat is going up, the market value of the flat is also likely rise over time.

So if the flat goes up in market value from the £200,000 that you originally paid to £210,000 one year later that’s an increase in capital of 5%. So rental income of 3% plus capital gain of 5% = total return of 8% per year.

Now lets move on to the stockmarket where exactly the same principles apply. There are two parts to your total return: income and capital gains.

Firstly there is the income. Imagine a company makes total profits after tax of £100m and then pays, say, one third of this to its shareholders in dividends.

If you buy £200,000 worth of shares paying you dividends of say £6,000 in year one, then you are getting a 3% dividend yield.  This is your dividend income that you can use to live off or to reinvest and buy more shares that will pay you more income and so on. 

Then there is the capital gain. Share prices go up. Not always and not every year. But over the long run they go up a hell of a lot more than they go down.

Remember those profits not paid out as dividend? The other two thirds (£67m) is kept and reinvested in the business. For example, it might be used to fund the building of a new factory or the development of new software. This makes the company more valuable and that drives increases in the share price and in the company’s market value.  This is why the stockmarket always trends upwards over the long term.

Dow Jones

If your shares go up in market value from the £200,000 you paid to £212,000 one year later, that’s an increase of 6%. So rental income of 3% plus capital gain of 6% = total return of 9% per year.

One of the most fundamental choices an investor can make is their asset allocation: your chosen mix between “engine assets” (e.g shares, property) and “shock absorber assets” (e.g cash, bonds). Engine assets give you a rollercoaster ride but, over the long term, the odds are massively stacked in your favour.

Remember: rollercoaster rides are very safe as long as you stay strapped in. Just don’t get out halfway through the ride. Did I mention that you should never be a panicked or forced seller of risk assets in a downturn? Yes, I think I did.

Investing is simple enough for anyone to do it. It’s totally normal to feel fear. Throughout evolutionary history, fear has been the ultimate survival mechanism. But most people are afraid of the wrong stuff. As Ramit Seethi puts it:

People are way, WAY more scared of the risk of a 25% drop in the stock market…than losing small amounts every day due to inflation, fees, & poor asset allocation, which add up to far more over a lifetime. This is one of the most costly mistakes in life.     


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7 comments

  1. Always good to hear a sensible article, but check the maths 🙂 “If your shares go up in market value from the £1,000 you paid to £1,006 one year later, that’s an increase of 6%”…

  2. Delete as appropriate 🙂

  3. Refreshing article
    thanks

  4. Thanks for a good article. My nitpick would be inflation. So a 9% return sounds great but if inflation is 5% it is really only a 4% return.

    I am interested in your views on the impact climate change may have on stock market returns. I agree that capitalism has been great for lifting millions (billions?) out of poverty over the past 150 years but the problem is 7bn people and rising getting richer means an exponential rise in resource requirements. Maybe I am an eternal pessimist but (unless the experts are wrong) I can’t see a happy ending for the planet let alone stock prices. Assuming (hopefully!) I am wrong I would love to know why.

  5. Of course, you also should note in your nice article that over 50% of the global wealth out there is kept by a very low number of people. I mean, a dozen or so people have more wealth combined than let’s say the next 3.5 BILLION people wealth’s put together. That is not capitalism, that is crony capitalism, a totally other beast than capitalism. Crony capitalism: you fixes the “game” in your favor, by blocking competition away, by getting cheap money that potential competitors can’t access, by getting laws voted that favor incumbents like you and protect your ‘moat’, by having large networks to get yourself preferential treatment compared to upstarts with zero networks. But I agree that we are now much better off than even 200 years ago, since everyone now has or can afford a fridge, microwave oven, a small pox inoculation shot, a telephone to watch YouTube and reading glasses, which a King even 200 years ago couldn’t even get.

  6. Of course this applies if you invest well and know what you are doing :

    https://awealthofcommonsense.com/2020/01/the-craziest-tales-of-financial-fraud-that-didnt-make-it-into-my-book/

    Crazy Tales of Financial Fraud (That Didn’t Make It Into My Book)

    Posted January 9, 2020 by Ben Carlson

    One of the hardest parts about writing my book on financial scams, frauds, charlatans, and hucksters was figuring out what to include and what to leave out. Every time I read a book or story about a ridiculous financial scheme it would be topped by the next one I read.

    Here are some straight from the cutting room floor than didn’t make it into the book:

    *******

    There was a pyramid scheme in China that literally sold pyramids (they called them “energy” pyramids). These pyramids were sold under the guise of having “healing” and “energy-absorbing” powers and cost upwards of nearly $15,000. And of course, people were recruited to sell them through a multilevel marketing sales program.

    *******

    Albania was a communist country for decades but was freed from central planning in the early-1990s. The country’s unfamiliarity with capitalism and financial markets created one of the largest pyramid schemes per capita ever concocted.

    Funds and companies were setting up standard Ponzi schemes where they would promise high returns on capital and payout early investors using money from later investors. And to keep up the fundraising these funds would continue raising their fake interest rates.

    The surprising aspect of this scam was the sheer scale of it all. The amount promised to investors at its peak reached nearly half of Albania’s GDP. And two-thirds of the country’s citizens invested in these rackets.

    When they finally blew up, economic output fell by 7%, imports fell by 25% and inflation rose to more than 40%!

    *******

    The book Chasing Phil (sounds like it’s being made into a movie by Robert Downey Jr.) tells the story of hustler, fraudster and provocateur Phil Kitzer and the two FBI agents who went undercover to take down his massive financial scam syndicate.

    The craziest part to me about this tale was not just how many fake business deals Kitzer was able to get away with but the behind the scenes of the undercover FBI investigation that brought him down. Jim Wedick and Jack Brennan went on a months-long undercover operation to infiltrate Kitzer’s group of con artists by be-friending the thief and getting to know how he operated.

    But undercover work was still relatively new in the late-1970s so Wedick and Brennan used their real names with Kitzer.

    The first time the two approached Kitzer in a cocktail lounge to set things in motion, Kitzer looked at the two of them and said, “Christ, you guys look like a couple of feds.”

    And they still ended up becoming part of his inner circle to get enough information to take him and his pals down.

    *******

    Richard Harley claimed he owned 10 billion barrels of oil worth a cool $1 billion along with a fine art collection. The basic pitch was, “Look how rich I am. Invest with me and you too can be rich!”

    Harley failed to mention he was living on $500/month of social security benefits and that’s about all he had. “Investors” still handed over nearly $325,000 before realizing there was no investment strategy at all.

    Nor did they realized Harley had encountered the law before, duping AIDS patients out of thousands of dollars by claiming he had a cure for the disease in the 1990s.

    *******

    Three card monte is an old con artist game where the dealer has basically no chance of losing. One of the early pioneers of this scam was William Jones, better known as “Canada Bill.” In the 1850s Bill was playing in a game of three-card monte but he wasn’t a dealer but a player.

    When another con artist saw Bill at the table he pulled him aside and asked, “Don’t you know this game’s crooked?”

    To which Bill shrugged his shoulders and replied, “I know, but it’s the only game in town.”

    ******

    The Spanish prisoner game was an early version of the Nigerian prince email scam. In the early-1900s thousands of people would receive the same letter detailing that the writer of the letter was a banker who had been jailed in Mexico. But before going to jail he tried to send hundreds of thousands of dollars over the border into the United States in a hidden compartment of a trunk.

    The trunk, these marks were told, was sent to the man’s beautiful daughter, who just needed $10,000 to get the trunk back from the Mexican courts, who had impounded it. These people were promised $150,000 out of the trunk and a $50,000 cashier’s check for their troubles.

    Doctors were the biggest marks in this con and many of them ended up traveling all the way to Mexico in search of a beautiful woman and six-figures in return for a $10,000 “investment.”

    Obviously, none of this was true and the Mexican con artists running this operation duped many a hopeful American out of their time and money. There was no beautiful daughter waiting, the cashier’s checks were fakes, and there was no money hidden in a truck somewhere.

    *******

    In the 1920s Joseph “Kid” Weil would set up fake brokerage houses to take advantage of the greed inflicted by the roaring 20s stock market boom. He told unsuspecting investors looking to make a quick buck that he could sell stock certificates worth $1 for $5.

    To prove hit sales pitch he would make a fake sale at his fake brokerage house for a handful of the stock certificates. The marks would then buy up the remaining certificates assuming they could make an easy profit. When they returned the next day to make their sale the entire operation would be gone, only to be re-opened a few weeks later somewhere else.

    *******

    The Kid was known as one of the great confidence men of his era but even con artists can fall prey to scams. Weil met a pretty woman on a cruise across the Atlantic who claimed she needed $10,000 to pay off her father’s debts, offering a pearl necklace as collateral for the funds.

    When the ship docked she told him to wait for her while she paid off the debts and worked on getting him his money back by other means. She never returned and the pearls were fakes.

    After realizing he had been taken, the Kid later said, “What a team we would have made!”

    It’s hard to believe how many stories I read like this about con artists who got conned.

    My book gets into much bigger financial fraud and scams than these but I couldn’t believe how many wild stories I came across where people were so frivolous with their money because of a good story.

    I go into many of the reasons why that’s the case including the psychology behind many of the biggest financial scams in history throughout the book:

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