Stocks are just ownership shares in a business. So, the first step in understanding why they go up is re-wording the question to “Why do businesses become more valuable over time?”

Let’s break down the Price to Earnings Ratio.  The Price to Earnings Ratio is just a mathematical way of showing the price people are willing to pay for each dollar of profits.  To get it you take the value of the business in the marketplace today and divide it by the profits it generates each year.

Historically, in the stock market, people have been willing to pay $16.50 or so for every $1 of profits a business generates.

That tells us then that there are two things that effect the price of a stock, the profits that company earns and the price people are willing to pay for each dollar of that particular company’s profits.

Let’s take these one at a time.

First, the profits.  This one is simple, the more profits a company makes, the more valuable that company is.  That’s pretty straightforward.  But let’s look a little deeper.  What exactly causes a company to make more profits?  Profits are just sales minus the costs required to make those sales.

So to increase profits you have to sell more stuff, spend less money to sell that stuff, or both.

Ultimately, in business, your success or failure is dependent on the people in that business.  It’s the people in the business that will enable it to sell more stuff or spend less money to sell that stuff,  or both.

And why would people want to do that?  Because it helps them improve their own financial situation.  This is the magic of free market capitalism.

The salesman in the business wants to sell more stuff so he or she will make more money.  Because any salesperson that can sell more stuff will either get paid more where they are or they’ll go to another company that will pay them what they’re worth.

The engineer and developers in the company want to design better stuff so it will sell better so they will make more money.  Because if you can design a better mousetrap, in general, it will sell more.  And anyone that can design better products and services than the competition will either get paid more where they are or they’ll go to another company that will pay them what they’re worth.

The accountants and bookkeepers in the business want to reduce expenses to the company whenever they can so they can make more money personally.  Because anyone on the financial side that can run the business more efficiently will deserve to be paid more than someone who runs it less efficiently and they’ll either get paid the right amount where they are or they’ll go somewhere else that pays them what they’re worth.

So, ultimately, its everyone’s self interest – the fact that we’re all constantly trying to make our own lives better and more useful to the businesses we work for, the more control we can have over our own lives – more money, more free time, etc.

Now, we’ve gone extremely deep so let me summarize:

Why do stock values rise over time?  Because their profits go up over time.

Why do profits go up over time?  Because they create and sell more and better stuff for less and less money over time.

Why does that happen?  Because everyone in the organization is focused on improving the stuff businesses sells, selling more of it, and/or spending less to sell it.

Why are they focused on that?  Because if they succeed in that it makes their own lives better – more money, more free time, more control over their own lives.

So ultimately stock values rise over the long term because everyday, you and I and everyone else get up, go to work, and try to improve our own lives by making the businesses we work for more successful.

This is the beauty of free market capitalism – it harnesses people’s self interest to improve the lives of everyone.  As free market capitalism has spread across the globe we have seen the greatest improvement in the standard of living, spread across more people of all nations, races, religions, etc. than has ever happened in the history of the world.

But the process by which free market capitalism works leaves it open to criticism – it’s ultimately harnessing a pretty selfish instinct.  People, in general, want more money than they have today even though people, in the Western world especially, have far more money than people had 100 years ago.  People, in general, want more free time than they have today despite the fact that we all live a life of incredible ease compared to people even 100 years ago, let alone 1,000.

But can you imagine a world where individuals no longer want to improve their lives?  I can’t.  Our lives are simply better when we have more money and/or more free time.  Free market capitalism is the only system ever devised that harnesses that instinct for the greater good.

So why do stocks go up?  Because you and I want to improve our own lives.

That should give us some real comfort in the midst of stock market and economic downturns. As long as the mechanism exists for us to make more money or get more free time by being more useful to our fellow man (in other words, as long as free market capitalism exists) then stocks and the economy will recover.

That’s because we’ll all keep working to create better solutions to the problems we face (engineering and development), we’ll all keep working to get those better solutions into the hands of more people (sales), and we’ll all keep working to do that at a lower and lower cost (bookkeeping/accounting/finance).

So until people no longer have the desire or the incentive to keep working to make their own lives better we can be pretty confident we’ll get through whatever setbacks the world throws at us.