4 Charts That Explain the Stock Market – A Wealth of Common Sense

This week I saw a chart from Bank of America that more or less sums up my entire investing philosophy:

In the long term, stock prices rise.

I see the stock market as a way to invest in innovation, profits, progress, and people who wake up in the morning looking to improve their current situation.

While I love the fact that this chart illustrates my long-term philosophy, it's a little misleading. Yes, the stock market goes up in the long term, but it can also get crushed in the short term. This can be difficult to see on a log graph with 200 years of data.

The Great Depression, the crash of 1987, and the Great Financial Crisis look like little dots on this graph. And while each dip eventually becomes a point on a long-term chart, they don't feel like doing that right now.

Looking at this chart got me thinking about what other visuals I would use to help explain the stock market in more detail. Here are some more:

You can't look at a stock market chart from top to bottom without taking into account the dips that occur along the way:

The Great Depression was not a temporary problem. It was a tsunami. People thought that the crisis of 1987 was going to lead to a depression. The financial system was on the verge of extinction in 2008.

Sometimes the stock market crashes. Sometimes it takes years to get the money back.

You don't get a long-term chart of a stock going up over time without sometimes getting your face ripped off. If you can't survive the short-term drawdowns, you won't be able to share in the long-term gains.

This is true for market crashes, run-of-the-mill bear markets, terrible years, and even good years in the stock market.

Another one of my favorite charts that helps explain the stock market is to look at annual returns combined with intra-year declines:

The average intra-annual drop since 1928 was -16.4%. Losses can be expected in the stock market.

The other takeaway from this chart is that declines occur even when the stock market ends the year in positive territory.

The average intra-year decline in years that ended with a positive return for the S&P 500 since 1928 is -11.6%.

Therefore, you should expect to experience downward volatility even when stocks are in an uptrend.

In fact, the average decline when the S&P 500 is up 20% or more during a given year is -11%. It has had to live through a double-digit decline in about half of all years of gains of 20% or more in the stock market over the last 95 years of profitability.

Think about it: to reach 20% or more you have to experience a correction in half of every year.

The other surprising statistic here is the large number of 20%+ returns seen in the stock market in any given year.

In 34 of the last 95 years, the US stock market has ended the year with gains of 20% or more. That's a larger percentage of years (36%) than the number of years that end with a loss (27%).

Of course, profits or losses in a given year are meaningless. All sensible investors know that the only time horizon that really matters is the long term.

Historical numbers have shown that the longer your time horizon, the greater your chances of success and the less variable your profitability range will be:

There are no guarantees when investing in the stock market.

Bad things can and will happen.

But if you have a time horizon that is measured in decades rather than days, months or years, you will be better off than most investors.

I can't promise that these relationships will continue in the future.

But I find it hard to believe that we are going to have a future where people are not innovating, progressing and waking up trying to improve their situation in life.

That's the lifeblood of corporate profits and that's why I believe in long-term stocks.

Michael and I talk about long-term stock market charts and much more in this week's Animal Spirits video:

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Other readings:
The stock market is not a casino

Now this is what I've been reading lately:

Books:

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