What looking back on the history of an index tells investors

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Copyright : Dima Zahar // 123RFIndexes have been around for decades, but what does all of that accumulated data actually tell investors?

The Russell 3000 index, which was created in 1984, captures approximately 98 per cent of U.S. traded equities. In order to fully replicate the U.S. market, an index would need to hold around 1000 more stocks, many of which have significant liquidity constraints, or have simply too small a market capitalization for major investors to buy into them, noted a report from FTSE Russell.

The report emphasized that the U.S. stock market can be a genuine reflection of the country’s economy. While an index and the country’s gross domestic product are manifestly different measurement tools, they tell similar stories about the U.S. economy’s health over time. The growth paths of the two measures have moved in relative tandem for four decades, although stocks have demonstrated a few peaks and valleys along the trend line.

Narrowing in on a specific time frame can highlight the key risk of equity investing, namely the risk of substantial losses over a given holding period, the report said. Between 2000 and 2009, for example, major events resulted in a very different equity returns, with stocks roiling through the bursting of the tech bubble and subsequently recovering only to tumble again during the global financial crisis.

Zooming back out, however, paints a different picture. “While the risk premium is never guaranteed over any particular period, the U.S. equity market has historically demonstrated “mean reversion” in that over time the market returns to some sort of long-term average,” the report said. “Periods of negative market performance are generally followed by periods of positive performance and vice versa.”

Parcelling out different investment periods, longer holding periods evidently reduce the risk of capital loss and decrease average volatility substantially, the report noted. “Of these historical holding periods, any 20-year holding period would have produced positive returns 100 per cent of the time over the last 40 years. Ten-year holding periods would have produced positive returns 95 per cent of the time and five-year periods would have produced positive returns 90 per cent of the time.”

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