When Markets Go Crazy

Worry much about your investments?  In volatile markets, it’s easy to feel uneasy.  Memories of 2008-2009, when the market lost more than half its value, are still fresh in everyone’s mind.  So when the market swings widely nowadays, investors get concerned.  Sometimes concerned enough to act.

Worry can drive investors to behave irrationally, and actually do more harm to their portfolios than good.  When the market is high, investors want to capitalize on the growth and tend to buy stocks.  Conversely, when the market is low, investors tend to run to safety and sell off their stocks.

This is the exact opposite of what an investor should do.

Schoolhouse Rock has it Right

Buy low and sell high is the name of the game.  The Schoolhouse Rock DVD has a song about this truth (although it was not shown as often – if at all – as the one about conjunctions).  The premise is that you want to buy when prices are low and sell when prices are high so that you make a profit.  This makes sense when one is thinking logically.  The problem comes in when emotions swing as high as the stock market swings widely.

Think of it this way.  You have a house.  You bought it at the top of the market in 2007.   Today, the house is worth less than you paid for it.  Are you going to sell your house today because it’s worth less?  Not if you don’t have to.  You’ll wait until the housing market comes back up, and the worth of your house improves.

In another scenario, let’s say you don’t own a house yet, or have some excess cash on hand.  Prices for housing are low.  Now would be a good time to buy, either for yourself or as an investment.  In this case, you would be able to profit in the short-term through rental income on the investment property, and in the long-term if/when you eventually sell the property.

The same goes for your money.  February of 2009 was the perfect time to invest more in the stock market.  Starting the beginning of March, the stock market began rising, and within a three months, had gained back more than 58 percent of its then current value.  That’s a 58+ percent return on the investment.  This phenomenon is so common in the market cycle that it has a name – the dead cat bounce (although a bouncing ball would be a more appropriate analogy).  It refers to the pattern that when the market bottoms out at its lowest point in the current cycle, most of the following growth occurs in the first bounce up.  Then it will drop again, but not as far.  The next growth event will not be as high as the first one.  And so on and so on.

If, due to panic, you sold out of your stock investments as the market was crashing to move to cash or at least safer investments, you’re selling at a loss.  Less skittish folk tend to have a lower stock price trigger point when it comes to selling, thereby making their losses larger.  When the market starts rising again, you may not trust that the run is sustainable, so you wait a while before you buy back into the market.  Not only do you realize the losses at the point of sell, you miss the time period of the biggest gains.  Thus your overall portfolio performance is harmed.

What to Do, What to Do

The only way to benefit from a market drop would be to sell out right before the bubble bursts to protect your profits, and then buy back in at the point where the market bottoms out to take advantage of the low prices and capitalize on the coming growth.  Most people – even professional money managers – cannot time the market this efficiently.

So what do you do instead?  The best thing to do is stay put.  It’s much easier to stay put if you are properly allocated according to your risk tolerance and time horizon.  If market drops make you nervous or if your time horizon is short, you should not be aggressively invested.  Likewise, if significant market losses don’t bother you as much or you have a long time horizon, then a more aggressive portfolio would be fine.  You need to understand, though, that in minimizing your potential for loss, you need to accept that your potential for gain will also be reduced.  You can’t seek high potential for gain with little to no risk of loss.

It can be hard to stomach the idea of staying put when the media sensationalizes the wide market swings.  It helps to limit your exposure to those financial talking heads.  In fact, there is data to support that staying put is the best option.  A Harvard study of investment habits found that investors who consumed no financial news earned better returns than those who were fed a steady stream of it.  Investors in volatile markets earned more than twice as much as similar investors whose trades were influenced by the media.  In financial challenges, maintain your emergency savings and limit debt, sure.  But don’t waiver from a sound investment plan.

Understanding What is Normal

It helps to understand that the market is normally cyclical.  The market goes up, then it goes down, then it goes up again.  It’s like radio waves.  Sometimes the swings are narrow, sometimes they are wide.  Over the very long-term, the overall trend is up.  The definition of long-term is relative, however; due to the 2008 crash, the stock market lost 10 years worth of growth, and 10 years is typically considered long-term.  To an extent, you can control the width of the swing through allocation appropriate to your risk tolerance.

 

So why does it seem the market swings more widely now that it used to?  You can thank computers for that.  In the olden days, buys and sells were conducted using actual people.  Now a lot of the buying and selling is computerized.  Computers operate much faster than humans, and can be programmed to buy and sell in huge blocks at specific triggers.  Large institutions have created computer programs that set target prices whereby if stock prices reach that point, the computer initiates a wide-spread buys or sells.  The target prices are generally not that far off current prices, but the bulk trading tends to result in driving prices further than the target – sometimes much further.  And it all happens pretty much in the blink of an eye.  There is no way a human can keep up with this pace, so one shouldn’t even try.

It All Comes Down to Risk Tolerance

You should base your investment portfolio on the amount of risk you are willing to take.  There are five major risk profiles:  conservative, moderately conservative, moderate, moderately aggressive, and aggressive.  Risk tolerance questionnaires can be found on the internet or from your financial advisor.  The questionnaires ask questions concerning your time horizon, your realistic expectations for growth, your sell-off trigger points for losses, and your overall comfort level regarding negative market performance.  Your answers to these questions help determine what risk tolerance level would be appropriate for you.  If you have multiple investment accounts, risk tolerance can vary from account to account; meaning your retirement account will likely have a different risk profile than your child’s education fund.  Your risk profile should be reviewed on a regular basis and adjusted as necessary to accommodate changes in your financial picture and life circumstances.

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