Is the Stock Market's Average Annual Compound Growth of Around 7% Sustainable?
" "When discussing the growth of the stock market, it's important to clarify some key points of terminology and economic principles. The term 'exponential growth' is often misapplied, and what is commonly referred to is a 'compound growth rate.' Any average growth rate, such as the 7% annual compound growth often cited, is a historical statistic that includes both positive and negative years. This average is a reflection of past performance, but it doesn't guarantee future results. It's essential to understand the factors contributing to this growth and whether it can be sustained in the future.
" "Understanding Compound Growth vs. Exponential Growth
" "The growth in the stock market is typically measured as a compound annual growth rate (CAGR), which represents the mean annual growth rate of an investment over a specified period of time. Exponential growth, on the other hand, refers to a non-linear growth where the rate of change is directly proportional to the current value, usually seen in scenarios like population growth or compound interest.
" "For instance, if the stock market has recorded a 7% compound growth rate over a long period, this means that the value of the investment grows by 7% each year, and that growth itself compounds over time. However, it's crucial to recognize that this growth can be volatile and subject to market fluctuations, making it neither reliable nor guaranteed for the future.
" "The Sustainability of Stock Market Growth
" "Despite the fluctuations, the stock market's growth can be considered sustainable for several reasons. Stocks offer a higher return than risk-free investments due to the inherent risks associated with investing in the stock market. This higher compensation can lead to higher returns, even surpassing historical averages. The relationship between stock returns and macroeconomic conditions is significant, but economic theory does not preclude stock returns from outpacing broader economic growth. This higher return is more closely tied to the risk taken by investors rather than macroeconomic conditions alone.
" "Comparing Stocks and GDP
" "A distinguishing factor between stock market growth and GDP is that the stock market measures expected future profits, whereas GDP measures the total value of production. Stock market returns represent a smaller portion of the overall sales and production, but they are a key indicator of corporate profitability. Technological advancements have significantly improved productivity, leading to fewer workers needed and higher profits for companies. This, in turn, results in excess cash that companies can use to repurchase their own equity, thereby increasing share prices.
" "The US is a net issuer of equity, and this is a situation that will likely accelerate. The combination of increased productivity and the natural ebb and flow of economic cycles can contribute to sustained stock market growth. Even in the long run, larger corporations tend to fall while smaller, emerging firms rise, which often results in stock market indices rising faster than the average stock on the market. Indices are constructed to dynamically include rising companies and exclude declining ones, which automatically skews the overall growth in favor of the index.
" "Conclusion
" "In conclusion, while 7% annual compound growth in the stock market is impressive, it is not guaranteed to continue indefinitely. The stock market's health and growth are influenced by a complex interplay of factors, including investor risk, macroeconomic conditions, technology advancements, and market dynamics. Investor vigilance and a well-diversified portfolio are crucial for navigating the complexities of the stock market and securing long-term financial growth.