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High Finance Stock market primer Sic Sequitur has an interesting post on the stock market, refuting the idea that stocks increase in value because the economy grows. The return on stocks can be thought of as composed of two components: risk-free rate and equity risk premium. Both are caused by holders of stocks requiring compensation for their investment. The risk-free rate compensates the holder for giving up consumption today in exchange for more consumption in the future. The risk premium compensates the holder for the volatility of returns: he doesn’t know exactly how much he will receive in the future, so he must be paid for taking on this risk. The growth of company earnings or value-creation in the economy are irrelevant. Stocks of fast-growing companies offer in aggregate the same (actually, there are reasons to believe that they offer lower) returns than stocks of slow-growing or shrinking companies. Stock returns in fast growing countries (for example, Japan) are no higher than stock returns in slower growing countries (say, Great Britain or Germany). I just found this blog. I'll continue to read it.
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