Ever wondered why financial planners and investment experts can be so sure that you will receive an average of 10% growth if you invest in a diversified portfolio over the course of your life.
You might say, history and data show that the market has averaged 10% year over year for decades...
Ever think about what makes a company valuable, what makes a stock price rise?
You might say, companies that produce more profits are more valuable?
True, but how do they produce those profits?
The growth in the stock market is directly related to the growth or value of companies. The more profitable or promise of future profit, the higher the stock price,
In history, the sum of these companies have produced profits that increased the stock price, thus providing an average return over time of 10% per year to the average investor.
But, what makes a company able to produce more profit over a sustained period of time? And, as importantly, how can we trust that companies will continue to do this over time.
How Companies Make Profit:
Profit is really creating a surplus of value. It’s optimizing the inputs to produce a greater number of outputs, more efficiently than others.
For example, if an amateur farmer and a professional farmer have the same amount of same amount of inputs (time, land, seed, fertilizer, equipment, etc.) Most likely the professional farmer would be able to produce more outputs (crops) than the amateur farmer, with the same inputs and less energy, due to knowledge efficiencies.
The more efficient the professional farmer, the more value the farmer creates.
Now, if the professional farmer has more land and more resources, the professional farmer is even better at optimizing the ratio of output, compared to the input.
When a company provides something of value, and are able to do that in a way that most efficiently uses the inputs, they create profit.
The better they are at this, the more profit or surplus they create. The more profit, the higher the stock price, or higher the value of the company.
So how can we be confident that companies will continue to grow collectively at a 10% return over time, thus confident that our diversified investments will grow 10% per year, on average, over time?
Consider that you aren’t betting on companies. You are betting human beings and our insatiable drive to learn, innovate, create and improve our experience.
Yes, the amateur farmer may not be very good the first year, but he/she will be better the following year and the year after that, and the year after that.
Collectively, as a human race, we are naturally inclined to improve, optimize and create value over time.
Decade, after decade, after decade.
Just look at transportation. Horses were more efficient than walking. Cars more efficient than horses. Electric cars and high mpg vehicles more efficient than the original cars. Uber, now perhaps more efficient than owning your own car.
In this present moment, technology is accelerating value creation faster than ever. It’s reducing the amount of inputs, particularly human energy, required to produce greater outputs.
The iPhone I’m typing this blog on is made my the most valuable company in the history of all time, Apple.
There are many reasons for Apple’s rise, but think about the value that is created from this little device: calendar, clock, radio, phone, communication made better by video, text and email, unlimited books, television, weather, games, networking, driving directions, shopping.
This is the most essential reason for Apple becoming the most valuable company in the world.
This is just a few of the aspects of the value that this little device provides that used to be served by individual pieces. It’s now wrapped into one convenient device.
That is value creation and that is why we mindlessly fork over a 1,000 every two years.
It’s a bargain.
It’s also why you can be comfortable trusting the trajectory of human ingenuity and value creation. It’s why your financial advisor will tell you that an S&P 500 index fund is a smart investment. It’s a bet on value creation of American companies.
Let me ask you this:
If you’re business isn’t growing as fast as you’d like, how can you increase the value you provide your customer, while reducing the inputs?
Need ideas? Let’s connect for some business strategy.