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A key reason for this approach is that in much of the world, economies benefit from technical innovations which help to increase their productivity. Combined with a rising global population and the demand for goods, this supports companies to sell more products and make more money. A company’s share price reflects what investors think is the current value of all its future cashflows. In the long term, successful companies will continue to generate higher levels of cashflow, driving adjustments to what investors will be prepared to pay for a stake in the company. In turn, as stock markets are made up of some of the best and most efficient companies, they can respond by rising in value.
It is important to recognise that stocks do not go up every calendar year and that markets move in cycles. 2022 was a punishing year for investors, while during the global financial crisis, the S&P 500 corrected 55% from its 2007 high. Yet over the long term, stocks in the US have risen roughly three out of every four years.
Some of the rise in markets is in response to the inflationary impact on a company’s revenues and returns, as companies raise prices to offset higher raw material costs. Note though that the uncertainty associated with excessive inflation (the US Federal Reserve targets a 2% annual inflation target) has historically correlated with periods of lower equity returns.
Compounding refers to the benefit you get by reinvesting any returns you receive on your investment. For compounding to be effective requires the reinvestment of investment returns and time.
The US equity market overtook that of the UK early in the 20th century as the dominant global stock market. Between 1900 and 2022 the benchmark S&P 500 rose by 9.8% a year and ‘real returns’, accounting for inflation, by a comparable 6.6% annually. On an annual basis, these are strong returns, especially considering the numerous geopolitical and financial market shocks that have occurred, including two world wars. Annualised real returns for the World ex-US over the same period were 4.5%. Much lower, the comparable annual returns for bonds in the US were 2%, and slightly lower for the World ex-US.
Source: Bloomberg, as at 31/12/2022
Remember that new names are entering and falling out of the S&P 500 and other stock indices on a regular basis as they are ‘rebalanced’. In the case of the S&P 500, this takes place on a quarterly basis. Criteria for inclusion in the S&P 500 include a market capitalisation of at least $8.2 billion and positive earnings during the most recent quarter. The sum of its earnings over the previous four quarters must also be positive. Meeting the above requirements does not guarantee index inclusion, but the larger a company’s market capitalisation, the greater the chance of membership.
From the importance of diversifying your portfolio to a five-point investment checklist, this guide highlights what to consider when investing in periods of market volatility.
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