The Stocks Shall Rise Again!

Here are some recent headlines you may have seen about the stock market:

• "Stocks Jump After Strong Economic Data"
• "Stocks Struggle Out of the Gate"
• "Stocks Shrug Off Rout"
• "Stocks Do Not Mean to Eat Each Other, but the Females Accidentally Bite Bits Off the Males During Mating"

OK, so that last one is from an ABC News report about giant squids. But we investors often discuss stocks as if they're living creatures -- as if they can jump, struggle, shrug, and bite all on their own. We study their behavior, like Jane Goodall living among chimpanzees in Tanzania, hoping to discern what gets them to grow and reproduce.

But stocks are just pieces of paper (or, more often, entries in a computer) that have little inherent worth. They're human inventions that have value only to the extent that more humans want to buy them than want to sell them.

Or are they that simple?

Let's take a look at the true nature of stocks, and the care and feeding they require to ensure your portfolio's survival.

What moves the market?
If you own equities, ask yourself this question: Why should stocks rise?

For many investors, the answer may be that earnings rise, so stocks should rise, too. But that correlation can be pretty weak. Check out the earnings-per-share (EPS) growth of the following companies in 2006, compared with how their stocks performed:

Now, you might say that one year is too short of a time period to measure -- and you'd be right. But stretching out the time frame may not guarantee investment success. In 1999, Warren Buffett wrote an article for Fortune magazine that discussed the overall stock market. He pointed out the level of the Dow Jones Industrial Average at two points over a 17-year period:

• Dec. 31, 1964: 874.12
• Dec. 31, 1981: 875.00

Buffett followed by writing: "Now I'm known as a long-term investor and a patient guy, but that is not my idea of a big move." From 1964 to 1981, GDP rose 400% and revenues from companies in the Fortune 500 rose 500%, yet the price of the Dow was flat.

"Stock prices is people!"
Stocks aren't made of recycled people (unlike the food in the 1973 movie Soylent Green), but the prices are determined by human beings. After all, stocks trade on a market -- a place where buyers meet sellers and agree on a price for whatever's being sold. Pull the curtain back from any movement in a stock's price, and you'll find two people -- whether they're individual investors or representatives of an institution -- agreeing to a transaction.

If all that is true, is an investment in the stock market today solely a hope that the masses will bid up your shares? Have you gotten a load of the masses lately? Do you really want to bet your retirement on them?

At some point, you or your beneficiaries will sell your stocks. You invest because you want to buy something in the future. But you can't pay for a vacation home with your brokerage account statement, and stocks don't make for good eating (unlike the people in Soylent Green). You first have to sell your shares to someone else, hoping that person is willing to pay more then than what you pay now. Is that a reasonable hope?

I think it is.

Bet on things getting better
To get to the absolute essence of investing, for a recent issue of my Rule Your Retirement newsletter I asked several experts -- money managers, finance professors, mutual fund pioneers, and authors -- the same basic question I asked you earlier: Why should stocks rise? If it's really a market, and prices are determined by supply and demand, who's to say there will be more demand than supply in the future? Is there anything investors can hang their portfolios on other than the hope that history will repeat itself?

Their answers were fascinating. Here, I'll highlight the response of John Bogle, founder of the Vanguard Group and hero to all Fools. As he points out in his latest book, The Little Book of Common Sense Investing, from 1900 to 2005 the earnings growth of companies was virtually identical to the capital gains of the stock market. As Bogle told me, "That is in the nature of the economic system. There will be innovation and there will be efficiencies, and capital will flow to where the returns are. That is what investing is all about. There will be depressions, and things will not look good. But in the long run, capital will be rewarded."

If you think the U.S. economy -- and the world economy -- will be bigger and better a decade or two or three from now, own a piece of that growth by investing in stocks. Yes, short-term emotions will drive stock prices today and even over the next few years. But over the long term, investors come to their senses and reward the owners of stocks for being the owners of businesses that grow over time.

Which stocks should you own? That's a great question, and it's something I discuss each month in Rule Your Retirement, with lots of talk of asset allocation and model portfolios. But a great start is Bogle's 31-year-old baby, the Vanguard 500 Index Fund (VFINX). You'll own little pieces of 500 of America's best businesses. And as far as we know, they're not made of recycled people, and they won't bite you at inopportune moments.

Want to see why other experts think stocks will rise? Give Rule Your Retirement a 30-day free trial by clicking here.

This article was first published Sept. 11, 2007. It has been updated.

Robert Brokamp should eat more things that are green. He owns shares of the Vanguard 500 Index Fund. NYSE Euronext is a Rule Breakers recommendation. Yahoo! is a Stock Advisor selection. Duke Energy is an Income Investor pick. The Motley Fool has a disclosure policy.