Why do we want stocks to go up?

By Felix Salmon
February 23, 2011
TFF:

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Comment of the day comes from TFF:

When asset prices go up, you are poorer.

When asset prices go down, you are richer.

That equation holds true as long as you are in the accumulation phase of your life. It reverses in retirement, and is perhaps ambiguous for somebody nearing retirement, but for somebody in their 20s, 30s, and 40s, it is undeniably true.

As someone who’s saving for retirement, this is clearly true. My preference is for assets in general, and stocks in particular, to be as low as possible for as long as possible, so that I can accumulate as many of them as I can before they go up and as few as necessary after they’ve become expensive.

But here’s the weird thing: most of the people cheering for the stock market to go up are in the accumulation phase of their careers, not the spending phase. They’re still putting money into retirement funds, and they aren’t intending on spending it for decades. So why are they so happy when stocks go up, and sad when stocks go down? Shouldn’t it be the other way around?

One good reason is that if you require a certain annualized rate of return over the years that you save for retirement, then every year that return is low only serves to push the necessary future return further and further out of reach.

A less good reason is the internalization of the false promise of compound interest — the idea that you want your money to be compounding from day one. In reality, yields go up when prices go down, and you still want to be able to compound at high yields, when prices are low, rather than at low yields, when prices have risen. If you can save for decades at a steady real yield of 5% with prices going nowhere, you’ll accumulate much more money than if you start saving at 5% and then rates quickly drop to 1%. Even after accounting for the capital gain on the first bonds you bought.

The main reason, however, is simply psychological. If asset prices go up, that means people with assets are richer, and have made money in the markets. If you’re rich and you’ve made money, that makes you happy. Even if over the long term you’d be better off if you were able to continue buying bargains.

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Comments
10 comments so far

I thought you were going to point that the stock market is not much more than a legal gambling casino.

I thought you might point to mac stocks as proof.

I though you might mention that a modest dividend and no increase in share prices might be better than than hoping to buy low, sell high, then get out before the INEVITABLE drop in value, in essence leaving some other sucker to take the fall.

Posted by SWARMtheBANKS | Report as abusive

“…so that I can accumulate as many of them as I can before they go up and as few as necessary after they’ve become expensive.”

I think this implies some determinism to asset prices that isn’t supported. If you own assets and they go up in price, you are richer. But it’s not inevitable that they will go in price before they go back up again. Which is why you dollar cost average, rather than waiting for assets to go down again before you buy more of them. Because you won’t know, at t = 0, whether they were relatively expensive or cheap, until at some point t > 0.

Posted by dlukas | Report as abusive

I think most investors also have a lick of common sense and realize that stocks are more likely to go up, say 5% a year for 30 years than to run flat for three decades, then shoot up 200% or so at the end.

Posted by RZ0 | Report as abusive

Glad you liked that comment, Felix. :)

To elaborate, I would hope for corporate earnings to increase while the share price falls. Consider Walmart — the earnings have literally TRIPLED over a decade, yet the share price today is at roughly the midpoint of the trading range from 2000.

The concept of “regression to the mean” doesn’t work very well, but “regression to earnings” is pretty reliable. If Walmart doubles its per-share earnings over the NEXT ten years, then either its stock will increase or it will be paying a 4.6% dividend while returning a similar amount of cash to shareholders through stock repurchases. Either would make long-term shareholders happy. (The danger, of course, is that their earnings stall. And if that happens, shareholders could easily lose money.)

dlukas, I was definitely talking about DCA and rebalancing. I am always invested in the stock market, typically with a 75%-80% allocation to global equities. Hopefully Felix is looking at it the same way.

My emotions seem to be wired backwards from most people, however. I’ve been gradually selling equities since December, feeling very nervous about the presently high valuations.

If you disagree? Maybe you’ll like this analysis better:
https://guidance.fidelity.com/viewpoints  /time-to-reconsider-stocks

Posted by TFF | Report as abusive

@RZO Actually your second scenario is, at least going by historical precedent, far more likely than your first.

Posted by CavelCap | Report as abusive

TFF – I think the computation of an individual’s change in wealth due to asset price movements is a lot more complex that expressed in your equation. Other factors to consider:

1) For most people, the plot of annual dollars invested against time is not a smoothly upward-sloping curve. If I spend 8 months unemployed, I’m probably not putting away anything that year; if I get a sweet bonus, I might invest more than 100% of my base salary. Investing behavior for most people is determined by surplus cash, not by the relative cheapness or expensiveness of assets–unless you want to argue that folks should just sit in cash until they think the market is right.

2) People also consume. If asset prices are rising, it’s likely that my expenses (housing, fuel, food) are rising too. I could hedge against those to some extent, but very few people do that. That means fewer dollars to invest, which impacts wealth.

Posted by dlukas | Report as abusive

Felix, for your theory to hold up you need to separate real returns and speculative returns. If I buy some bad land for $1000/acre and then find out it has millions of gallons of recoverable oil under it, my wealth has increased. If I buy the same land and find that speculators are theorizing that bad land is the next big thing, bidding up the price to $2000/acre, I should sell to them and they will probably then lose money, leading to no true net increase in wealth. Sometimes asset prices go up because the value of the future consumption they enable goes up. Sometimes they go up because of speculative fervor. The two are not equivalent.

Also, to the extent that a person cares more about individual wealth than societal wealth, even speculative bubbles are selling opportunities that can make the individual wealthier (particularly if he or she can redeploy his capital into a different, undervalued asset).

Posted by najdorf | Report as abusive

dlukas, like any aphorism it is a simplistic description of a piece of a much more complex puzzle.

I don’t see how you are interpreting that as advocating market timing. While I do rebalance continually, I’ve never been one to sit on cash hoping for an opportunity to come my way. As we saw in the 1980s and 1990s, a bull run can be VERY long — and the crash at the end usually won’t take you all the way back to the beginning.

If you want a more precise statement, instead of a one-liner, I would suggest that (as somebody who is still roughly 20 years from retirement) the movement of the stock market over the next year has almost no influence on my wealth. The market could increase 30% or decrease 30%, and at the end I would still own the same shares of the same companies (plus whatever additional savings I’ve added over the year).

As I said above, I’m still 75% to 80% in equities. The market rally had pushed me well above that, so I’ve been selectively trimming to get back down to my comfortable range. Definitely don’t advocate moving large swings of money in and out of the market.

Not sure I understand your second comment. Stock prices are largely independent of inflation. In fact, inflation tends to be BAD for stocks because the increasing capex sucks up cash flow. Inflation spiked between 1973 and 1981 (roughly) — with the S&P500 starting and ending that period around 120. It could be considered a “lost decade”, except that $120 was worth a lot less in 1981 than in 1973.

Many parallels between the current situation and that of 1973.

Posted by TFF | Report as abusive

“Many parallels between the current situation and that of 1973.”

I fear that TFF has hit the comment of the day again with that quote.

High and rising energy prices… Check
High unemployment… check
Massive overseas war spending… check

Best hopes for a peaceful and prosperous turn of events.

Posted by y2kurtus | Report as abusive

Good morning, y2kurtus. Want to see something uncanny? Pull up the chart for the S&P500 between 1/1/1969 and 2/24/1973. (Yahoo’s financial charts go back this far.) Now pull up a chart for the past four years, 1/1/2007 through 2/24/2011. Near-perfect match? Maybe one of the charts whizzes can put together an overlay?

Now look ahead at the ~8 years following that. The S&P500 didn’t set a new high until mid-1980, with massive inflation for the intervening years.

The scariest thing IMHO is that we are more vulnerable today than we were then. Massive budget deficits, spiraling national debt, high unemployment… And asset prices (while they’ve followed a similar pattern) are well above where they were in 1973 according to the graham-shiller index.

Very hard to see how that works out to peace or prosperity.

Posted by TFF | Report as abusive
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