Why does the stock market do this?

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When most folks hear that the average, long-term return of stocks is some specific number, they often assume that this return is achieved in a linear fashion, like a high-rate CD that grows steadily every year.  But the equity markets historically have not worked this way.

This is how the typical investor wants their equity holdings to perform:

Joe's Graph 1

Based on history here’s what more likely to happen:

Joe's Graph 2

Why do stocks behave this way?  We can’t know for sure, but maybe the market and its millions of participants are simply going through the process of determining the price of stocks on any given day.  Because there’s no special formula that defines what stocks are worth, buyers and sellers attempt to assimilate all available information (including both their rational expectations and their often times irrational emotions) to arrive at some price.

This dynamic process of price discovery, particularly over the short term, can cause the prices of stocks to jump around more than the typical investor would like. And yet even with this short-term volatility, stocks have been able to deliver quite favorable rates of return above inflation over long periods of time.

History has shown that it is possible to build wealth by investing in the equity markets over the long run. But there will not always be smooth sailing.  Usually, to get to the top of the mountain you have to hike through some rather difficult terrain.

About Joseph Marques

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