Why do Share Prices Rise?

Over any long period, shares in companies have always, hitherto, outperformed all other investments and the reasons are given below.

Inflation

A company can raise its prices and thereby its profits, in line with rising inflation, all other things being equal and provided there is no government intervention. However, it should be noted that this simple relationship breaks down in times of high inflation, when a government intervenes. The company has to pay high prices for its raw materials, but may be restrained by government edict (a 'prices policy') from raising its prices sufficiently to compensate.

The ability to raise dividends and capital values in line with inflation is not shared by bonds or gilts (unless index-linked), but is shared by property, paintings and related forms of investment. However, governments may impose periods of restraint on dividend growth as part of a general prices and incomes policy. This was last seen in the late 1970s under a Labour government.

The exceptionally high levels of inflation which British investors have to endure, much higher than those seen in the USA, Germany, Japan or other principal stockmarkets, mean that there is always a strong upwards pull on share prices. When inflation averages ten per cent per annum, share prices have to rise ten per cent just to stand still in real terms. This means that long-term investors in this country should always base their investment decisions on the premise that the stockmarket will rise in value.

It is possible to make a profit from a falling stockmarket by a variety of means. For example, buying 'put options' or 'selling stock short', which means that you sell shares today in the expectation of buying them back cheaper at a later date. However, the upwards drag of inflation makes this a very risky pastime for any but the shortest of periods.

The Employees Care

The directors and workforce of a company have as much, or more, interest in the well-being of the company as the investor. They will strain every sinew to raise the profitability of their company (and thereby improve salaries and job security), thus working indirectly for the investors' benefit. Strictly speaking, the directors are supposed to work directly for the investors' benefit anyway, but it has been observed by industry analysts that many are more interested in empire building. However, manufacturing improvements, economies of scale and the like will all be working in the investors' favour.

In the Long Term

In the long term, companies may reasonably be expected to pay increasing dividends to their shareholders and the share price should continue to rise to reflect this increase. Pension funds and insurance companies calculate their returns to policy holders on the basis that long-term benefits from shares will exceed increases in wages by at least two per cent. Also that long-term growth of the share value will be of the order of 6-8 per cent per year.

It is particularly instructive to compare the gains made from a building society higher-rate interest account and the growth in income from an 'average company' (actually an investment trust).