That stock markets can experience sudden drops in value is widely understood. The S&P500 experiences drawdowns of 10% or more in about 70% of calendar years. Yet “corrections” never fail to grab the headlines and cause investors to doubt their investments. In contrast, these times are when it is most important for investors to be confident in their long-term plan. Understanding the differing forces that shape short-term and long-term returns is fundamental to being a successful investor.
Why can markets fall so quickly? A stock market is simply a place where buyers and sellers convene to exchange shares. Only a small number of a stock’s outstanding shares are available to trade each day (most stockholders are neither buyers nor sellers at any given time). When enough market participants decide to sell at the same time, sellers suddenly outnumber buyers, leaving sellers scrambling to sell at ever-decreasing prices – in effect creating a buyer’s market.
Predicting this kind of imbalance is called “timing the market”. It sounds good in theory. In practice, it rarely works because foretelling short-term market moves is fraught with error. Some investors try anyway, which is why the “average investor” tends to underperform in the long run.
Short term price fluctuations are driven by (sometimes subtle) changes in profit expectations. In theory, a company is worth all the profits it will ever make, discounted into today’s dollars. Those future profits are unknown and complex calculations are used to divine a reasonable expectation of what they might be. There are as many different profit estimates as there are investors, and stock prices reflect the combined expectation of investors as a whole. But change a variable in investors’ calculations and profit expectations will change, sometimes dramatically. A dip in profit expectations can result in sellers flooding the market and driving down stock prices.
The long term is a different story. Over time, companies report real profits, and they grow their businesses, reporting again with (ideally) even greater profits. This historical profit growth is reflected in long-term stock prices. In the long term, stock prices are influenced by actual profits, not expected profits. This is why, for example, a particular stock may trade around $100, and not around, say, $20. The price is a reflection of the level of profits the company is achieving. Yes, the price will jump around in the short run along with changing profit expectations, but trend higher in the long run as actual profits accumulate. This trend is the reason to invest in stocks for the long term and to accept short-term fluctuations (albeit grudgingly) in the service of the long-term outcome.
Some investors are their own worst enemy, becoming distracted from their long-term plan by short-term thinking. One aspect of this is “herding” or following other investors. That can mean buying into a hot stock for the fear of missing out. More harmfully, it means panic-selling during a market downturn.
Investors who maintain perspective and stay mindful of their investment time horizon are more likely to achieve their investment goals than those who react to short-term market fluctuations. Staying invested and trying not to time the markets can reduce fluctuations over the long term. Fluctuations in value tend to smooth out over time as the impact of market volatility diminishes. Years of strong stock markets can outweigh periods of decline, resulting in long-term returns that outperform other asset classes.
In periods of market volatility, some investors tend toward safer investments, hoping to avoid further losses. This can result in needlessly locking in losses on investments that, given time, are likely to recover. Selling at the wrong time and missing just a few days of a market recovery could have a significant long-term impact.
Volatile markets provide the opportunity to assess risk tolerance in a real world environment (not just on a questionnaire). When markets are rising, investors tend to become over-optimistic and build up a greater appetite for risk. Not surprisingly, when markets go down, investors abruptly lose their appetite, but by then it can be too late. Risk tolerance should be based on long-term goals and given a periodic reality check to make sure it hasn’t drifted too far up or down with the markets. With the help of a professional advisor, your portfolio should reflect only the risk you can bear.
For a second opinion on your investments, we would be pleased to speak with you. We offer a complimentary second opinion service.
For further reading, please see our articles on volatile markets and staying on a long-term plan.