Stock market investments provide opportunities for independent wealth and an improved standard of living. As part of your own wealth-creation process, it is critical that you research the historical rate of return for the stock market to better understand the risk vs. reward profile for stocks. From there, you can put together an investment portfolio that matches your savings objectives and your risk tolerance.
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In America, the Dow Jones Industrial Average, S&P 500 and NASDAQ Composite Index are the three major gauges of stock market performance. The NASDAQ Composite Index is more so associated with the technology economy, as it includes stocks such as Amazon.com, E-Bay, and Google.
The Dow Jones Industrial Average and S&P 500 track large-capitalisation stocks, such as Exxon and McDonald's. The Dow is a price-weighted index, where the highest-price stocks carry most influence over the average. Share price, when compared to business value, is actually arbitrary. For example, IBM may have a higher share price than Exxon, but Exxon is the larger company.
The S&P 500 is a market--weighted index that ranks stocks according to their market valuation. The S&P 500 is therefore the best indicator for stock market performance.
The S&P 500 has averaged an 11 per cent annual rate of return since its 1957 inception. This rate of return includes several peaks and valleys that coincide with the economic cycle of growth, recession and recovery.
The S&P 500 surged throughout the late-1990s' technology boom. The index posted 38, 23, 33, 29 and 21 per cent returns between 1995 and 1999. When the technology bubble collapsed into recession, the S&P 500 lost 9, 12 and 22 per cent of its value between 2000 and 2002. The S&P 500 suffered a 37 per cent loss in 2008 -- during the housing crisis.
Stock market performance features a negative correlation to the prevailing interest rate environment. This means that low interest rates are often a catalyst for strong stock market returns. Low interest rates reduce borrowing costs for individuals and corporations, and encourage them to spend and invest money. At that point, stocks are also more attractive in comparison to interest-bearing assets. For example, you would be more likely to embrace stock market risks when money-market accounts only pay out 1 per cent interest, as opposed to 7 per cent. Expect the Federal Reserve Board to cut interest rates amid recession -- to spark increased economic activity and stock market returns.
Historical stock returns are not guaranteed indicators of the future. Short-term stock price movements are nearly impossible to predict because share prices account for infinite amounts of economic factors. These factors include tax law, foreign exchange, corporate profits and commodity supplies.
The Securities and Exchange Commission (SEC) recommends diversification to manage stock market risks while also allowing for long-term growth. A diversified portfolio may include both stocks and bonds. In recession, the bonds generate interest income to stabilise the portfolio. When the economy recovers, you can then expect your stocks to turn in strong gains.
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