Historically, the market has only gone up by 5.7% per year.
I bet you thought it was more.
But, that's not the full story. When calculated in a different way, the historically-based number could be more than twice as much, at 12.1%.
Believe it or not, both figures—the 5.7% and the 12.1%—are entirely accurate.
And, I’ve seen them both used to mislead you (depending on what the speaker/author is trying to get you to do).
I’ll walk you through the math so that you’re as prepared as possible the next time someone’s trying to convince you one way or the other…
More...
Same Coin; Two Sides
If you’re working through your financial plan, you’ve been told some story about what “the market” has done in the past.
If someone is trying to convince you that you should have a greater sum in the market, you’ve probably heard that it has historically averaged 10%, or maybe even 12% per year.
On the other hand, if someone is trying to convince you that you should put your money elsewhere, you’ve probably heard a much lower figure, like 6%.
Well… which is it? Where are these numbers coming from and which should we use for our planning considerations?
The Market
First off, we should probably define "the market" as there are, in fact, many markets in the world of investments (we'll explore the most relevant to you over time). In most cases—in most finance-themed conversations where "the market" is mentioned—however, people are referring specifically to the stock market.
(Now, I’m assuming at this point that you have a basic understanding of what a stock is. If not, that’s okay, you can check out this old video.)
In an attempt to track the performance of the stock market as a whole over time, a few indices are relied upon.
The Indices
An index tracks a group of investments as opposed to just one individual stock. There are three major indices:
- NASDAQ 100
- Dow Jones Industrial Average (DJIA)
- S&P 500
If you follow stocks anywhere, you’ll see these three more than anything else front and center.
The NASDAQ (National Association of Securities Dealers Automated Quotations System) is generally thought of as representing the technology sector. In fact, however, it’s made up of the 100 largest non-financial (not just tech) companies. It can provide a fascinating insight into the rapid growth of many of the most innovative companies in the world. But, it’s not a good representation of the entire stock market.
The Dow is made up of companies from all different sectors, but… only 30 of them. No matter how large each is, that’s hardly a large enough subset to give us the best glimpse into the performance and health of the stock market (in fact, it’s kind of just used as a token measure at this point…).
The S&P 500 is made up of the 500 largest US companies—which represents roughly 80% of the total US stock market. (