"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets."
- Peter Lynch
Market Performance & Economic Cycles
Market cycles & Indexes
Like mentioned in the above video, there exists a market for everything. But how do you measure 'the markets'?
Indexes are meant to replicate parts of the financial markets allowing them to monitor overall price changes in the market. Since it would be nearly impossible for anyone to monitor every price change of every asset, they are aggregated into indexes. Indexes are often used to measure the health of the financial markets. However, for the ease of construction, often only a part of the market is replicated. Some examples of well-known indexes:
The Dow Jones Industrial Average (DJIA) aggregates a combination of 30 US companies.
The Standards & Poor 500 (SP500) aggregates the 500 companies that are most held by investors and covers approximately 70% of the US market.
The Nasdaq100 is composed of the 100 largest companies in the US, excluding the financial sector. De facto it holds a majority of tech companies.
Today, either the DJIA or the SP500 are most commonly used as indicator for the health of the market.
How did the market perform over the past years? Research shows that after taking into account the major economic recessions (1930, 2008, and others), and corrected for inflation, stock markets provided annual returns of 5,1%, bond markets at 1,8%, and savings accounts 0,8% . This means that if you would pay a beer for USD 1 in 1900, and you would have chosen to invest USD 1 in a broad-market stock index back then, today you would be able to buy 337 beers today. Otherwise said, you would be 337 times more wealthier. If you would have done the same in bond markets and in your savings accounts, you would be respectively 8 and 2,5 times wealthier today. This staggering effect, and difference is a result of the power of compound interest. It also shows that in the long run, people are way better of investing into stock markets and bond markets, instead of in your savings account.