The Two Games You Play When Investing in Stocks

There's a fundamental truth at the heart of that many people miss, but it's the key to long-term success. Warren Buffett put it best when he explained that what owners can earn, in total, is limited to what their businesses earn in total. Think about it: over time, the combined gains of a company's shareholders can't magically exceed the actual business gains of the company itself.

When a stock's performance gets out of sync with the company's performance, some shareholders might get a temporary win, but it comes at the expense of whoever is on the other side of that trade. In the long run, the scoreboard has to balance. This is one of the most important concepts for anyone to grasp. The long-term returns from the are directly linked to the long-term returns earned by the businesses themselves—specifically, their dividend yields and earnings growth.

Investment Return vs. Market Hype

This isn't just a nice theory; it's backed by over a century of data. If you look at the U.S. stock market from 1900 through 2016, the average annual total return was 9.5 percent. But where did that return come from?

The answer lies in breaking it down into two parts:

1. This is the engine of wealth creation, driven by business fundamentals. It’s made up of the average dividend yield (4.4%) and the average annual earnings growth (4.6%). This is the real, tangible value businesses generated.
2. This tiny slice of the pie comes from changes in investor sentiment. It’s about how much people are willing to pay for a dollar of earnings, measured by the price/earnings (P/E) ratio.

When investors are greedy, P/E ratios soar. When they’re fearful, P/E ratios plummet. These emotional swings create short-term noise, momentarily knocking the market off its steady upward path. But over the long haul, the total return you get from almost perfectly tracks the underlying investment return. Any major gaps between the two have always been temporary.

The Market's Magnetic Pull Back to Reality

This tendency for stock returns to snap back to their fundamental baseline is a powerful force called "reversion to the mean." There have been times when the got way ahead of itself, fueled by pure speculation—think of the late 1920s, the early 1970s, or the dot-com bubble of the late 1990s. In each case, it was only a matter of time before market returns were pulled back toward the long-term average, like a magnet.

The reverse is also true. After periods of poor performance, like the late 1970s, returns eventually recovered. The problem is that we often get caught up in the short-term drama and forget this history. The volatility we see in yearly stock returns isn't usually about the economics of the businesses; it's about the emotions of the investors, reflected in those fluctuating P/E ratios.

This is why just looking at past market returns can be a deeply flawed guide to the future. The great economist John Maynard Keynes pointed out that it’s dangerous to assume the future will look like the past unless you understand the past happened the way it did. He distinguished between —forecasting the real, long-term performance of a business—and —forecasting the psychology of the market. This is the core of .

A Tale of Two Returns, Decade by Decade

When you break down returns by decade, this split becomes incredibly clear.

The investment return—dividends plus earnings growth—has been remarkably consistent. Outside of the Great Depression, it was positive in every single decade since 1900, typically landing somewhere between 8% and 13% annually.

In contrast, the speculative return has been a wild ride. It caused massive swings from one decade to the next. But here’s the fascinating part: without fail, every decade with a significantly negative speculative return was followed by a decade where it swung back to positive, and vice versa. The downbeat 1940s were followed by the booming 1950s; the grim 1970s gave way to the soaring 1980s. This is reversion to the mean playing out on a grand scale.

Over the entire 116-year period, all that chaotic up-and-down from speculation added just 0.5 percentage points to the annual return. The heavy lifting was done by the actual businesses. The message is simple: economics, not emotions, controls long-term equity returns.

The Real Market vs. The Expectations Market

To truly understand this, it helps to think of as playing two different games. Roger Martin, a former business school dean, described them perfectly.

The first is the . This is where companies compete, spend money, sell products, earn real profits, and pay real dividends. It’s about strategy, innovation, and tangible value.

The second is the . Here, stock prices are driven not by actual profits or sales, but by what investors to happen. In the short term, prices only go up when expectations rise. This market is about speculation—trying to guess what everyone else will do next.

The itself can be a giant distraction from the real business of investing. It pushes us to focus on fleeting, volatile expectations instead of the slow, steady accumulation of value from corporate America. My advice is to get out of the expectations game and focus on the real one. Ignore the short-term noise and concentrate on the long-term economics of the businesses you own a piece of.

Benjamin Graham, the father of value investing, captured this perfectly. He said that in the short run, the market is a "voting machine," tallying up popularity and sentiment. But in the long run, it's a "weighing machine," measuring the true substance and value of a business. He urged investors to think of the market as an emotional business partner, Mr. Market, who offers you a different price for your shares every day. Sometimes his price is fair, but often it’s ridiculously high or low based on his mood.

A prudent investor doesn't let Mr. Market’s daily whims dictate their view of their holdings' value. Instead, they use his quotes for their convenience—to buy when he’s pessimistic or sell when he's euphoric. The rest of the time, the wisest thing to do is simply ignore him and pay attention to your companies' operating results.