Committing to a long-term investment strategy could help you avoid making any quick-trigger decisions and ultimately, mistakes. 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.
Markets rise and fall
It is important to recognise that stocks do not go up every calendar year and that markets move in cycles. 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.
Inflation works its magic
Some of the rise in markets is in response to the impact of inflation on corporate 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 has sets a 2% annual inflation target) has historically correlated with periods of lower equity returns.
The benefits of compounding
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.
Evolving benchmarks to represent the strongest companies.
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 $20.5bn 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.
