Key drivers of stock returns

As we learned before, stocks have the highest historical returns among main financial assets. But you may still wonder whether the stock return is reliable and sustainable.

Why?

Suppose you’re planting an apple tree. There is no doubt that growing fruit trees requires time, commitment, and money.

Where can you get enough start-up capital?

You can raise funds from investors interested in this apple business. Each investor is a shareholder of the tree and owns a portion of the shares. A share represents a part of the ownership of the tree, which means that shareholders can be co-owners of apples in the future.

When you have enough money, you start to plant the apple tree and care for it with effort. The growing process is like a business operation. To have ripe, juicy apples, you must spend time and effort in the early days.

If the tree grows well, you will have a chance to reap apples during the harvest season. These apples, the returns of investment, will be distributed to each shareholder of the tree.

In addition to apple trees, there are also various fruit trees in the orchard. If a specific stock is viewed as a fruit tree, then the stock market is similar to an orchard.

The stock market is a place where stocks are issued, bought, and sold. In the orchard, you can trade shares of fruit trees. In the stock market, you can deal in shares of stocks.

We all enter the market for high returns. But do you know how the profits are generated?

For an apple tree, there are two main ways to generate gains. One is the fruit, and the other is the growth of the tree.

Similarly, stock returns also come from two aspects. The “dividend” paid to investors is like the fruit. And the “growth” in company value, like the growth of the tree.

That seeds grow into apple trees is a process under the law of nature. Typically, in the early stages, it grows at a fast speed. Like many successful startups, when their products are introduced to users in the beginning, the companies tend to experience exponential growth.

At the stage of full maturity, the tree begins to bear fruits steadily. It's common that many high-growth companies gradually slow down their growth after years of competition.

Normally, we can categorize companies into two types: growth companies and mature companies. Investing in growth companies, you will receive a small number of dividends but can benefit from robust growth in the future. Investing in mature companies, you will have stable returns with relatively high dividends.

For example, Tesla, an electric carmaker, has never paid a dividend since its IPO in 2010, but it has posted robust sales growth. In contrast, while Coca-Cola’s sales performance has stagnated over the past 10 years, it continues to pay high dividends to its shareholders.

Why do so many investors love growth companies?

Keep in mind that the return of growth is usually much more considerable than that of dividends. This means that if you bought shares of Tesla and Coca-Cola 10 years ago and held them until 2021, you could make more money from Tesla investment.

To sum up, investing in stocks is like planting trees. If you spend more time and effort, you are more likely to reap fruits. In addition to time and effort, learning methods and strategies are necessary.

The following chapters will focus on these aspects.