Each stock's rate of return in a given year consists of a dividend yield (which might be zero) plus a capital gains yield (which could be positive, negative, or zero). Such returns are calculated for all the stocks in the S&P 500. A weighted average of those returns, using each stock's total market value, is then calculated, and that average return is often used as an indicator of the "return on the market."

Question

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The question describes a process where each stock’s annual return is composed of a dividend yield plus a capital gains yield, and then these returns are averaged using each stock’s total market value as the weight. This weighted average return is commonly interpreted as the return on the market.

Option: True

Reasoning for the statement:
- Each stock contributes its own total return (dividends plus price change) for the year, which aligns with the definition of a total return.
- When we weight each stock’s return by its market value (i.e., price times shares outstanding or market capitalization), we obtain a value-weighted average return across all stocks. This is the standard method financial analysts use to estimate the overall market’s return, since larger companies (with bigger market values) have a proportionally larger influence on the aggregate performance.
- The process described—calculate returns for all S&P 500 stocks, weight them by total market value, and take the average—produces what is commonly referred to as the return on the market, closely approximating a value-weighted market index return (even though it is not a formal index construction, it serves as a practical proxy).

Why this is correct conceptually:
- It uses total returns (dividends plus capital gains), which is essential when discussing overall market performance rather than price-only returns.
- The weighting by market value ensures that the market’s aggregate performance reflects the impact of larger firms more than smaller firms, which is consistent with how many market benchmarks are constructed (value-weighted indices).

Why the other formulations (if presented) would be incorrect: since only one option is provided (True), there are no alternate statements to evaluate here. However, in general, statements claiming the market return should be calculated using equal weights, or using price changes alone without dividends, would be inaccurate given the emphasis on total return and value weighting described in the prompt.

In summary, the described method—computing each stock’s total return and then forming a market-value-weighted average across all stocks—accurately represents the concept of the market’s return.

Business Finance Chapter 02 Practice

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