Sounds familiar? I am sure it does! You would have heard this many times before, from many people, including me!!

And that is because it is true! Let's examine why.

We all know about volatility of the stock markets. One day, the market would move up by a couple of percentage points, and on the next day, it would fall! All of us have seen this, right?

Does this mean that stock markets are unpredictable? Well, in the short term, yes. No one can predict where the market would be the next day or week. (Not even the futile exercise of technical analysis - please read "An introduction to Technical Analysis" for more details.)

But we can predict where the market would be after a couple of years, and with a fair amount of accuracy. To understand why, we need to look at the factors determining the price of a stock.

How is the price of a stock determined?

Of course, a simple answer is - it depends on the demand for the stock. If there is more demand for a stock, its price would go up. And if there is less demand for a stock, its price would go down.

But how is this demand determined?

On a day-to-day basis, the demand gets affected by short term factors like news flow, politics, price movements of other tradable goods like commodities and crude oil, etc. Any change in these factors causes a fluctuation of demand, and thus causes a fluctuation of the prices of stocks.

But in the long run, the demand, and thus the price of a stock, depends on the overall state of the economy, its growth rate, and the growth rate of individual companies.

Let's understand this in detail.

Most companies make a profit, and this profit, expressed per share, is its Earning Per Share or EPS. When people invest in a company, they are willing to pay a certain multiple of this EPS as the price. This multiple is called the PE Ratio.

Now, in general, companies grow over years. Their sales grow, and their profits grow too. (At the least, we should consider only those companies for investment that are growing, or have a potential to grow)

This means that their EPS would also grow over years. Now, even if investors are willing to pay the same PE multiple for the company, the price of the stock would increase because its EPS has increased.

Example

Say a company has an EPS of Rs. 10, and is trading with a PE of 12. Thus, its stock price is Rs. 120.

After two years, if its EPS is Rs. 15, and if it would trade at a PE of 12, its price would be Rs. 180.

(The PE for a company also changes over time depending on the growth rate of the company and its future prospects. To know more, please read "Re-rating demystified").

Thus, a company's stock price would naturally, and certainly, go up in the long run by virtue of growth in its profit.

And therefore, investment in stocks for the long term always makes money.

Of course, the challenge is to invest in companies that are growing, and would keep growing. Discovering such companies requires considerable expertise and time. Therefore, it is wise to invest in stock markets using mutual funds, which would do all the hard work for you! Please read "Direct investment in Stocks versus Mutual Funds (MFs)?" to know more about this.

Even from income tax point of view, stocks present a favourable picture - long term capital gains from stocks is exempt from income tax! Even more reason to invest in stocks, and for the long term.

How long is Long-Term?

How do we define this "long term"? I believe that long-term for stocks means at least 5 years. This is a reasonable time to remove the impact of all short term fluctuations from stock prices. In my opinion, this is the minimum time in which the true change in value of a company would be reflected.

Evidence

Let's look at hard numbers and see if they support what I have said!

So, we see that stocks do beat other asset classes in the long term! (Although the difference in return between stocks and some other asset classes seems minor - for example, Real Estate - in the long run, it can have a huge impact on the overall growth of your investment. Please read "Goal Based Investing" to know more.)

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