What to do when the market crashes
You’ve seen the headlines. World markets plummeted overnight. Europe down 3 per cent. The US down over 4 per cent. The local market will follow suit.
It’s hard not to be moved by these drops. How can we not take it personally, when it hits us where it hurts – the proverbial hip pocket?
The interesting thing about last night’s drop (and today’s reaction) is there was no particular catalyst. Of course, you’ll hear lots of guesses as to what has motivated the traders, but none of it will relate to a particular news event or fact that has suddenly come to light.
Instead, the market is being moved by nothing less than a change in confidence levels. We’re not downplaying that fact – more often than not, changes in so-called ‘sentiment’ are responsible for a lot of the volatility in the market. Sometimes it’s based on hard data, other times it’s just the herd running one way or the other.
Memories are short
In 2008 and 2009, we created a label for one of the biggest economic downturns in modern history – the GFC. Markets dropped precipitously, the end of the financial world as we know it was proclaimed as being nigh by some commentators. The S&P/ASX 200 index fell almost 55 per cent between October 2007 and March 2009.
Since that point, shares have rallied 37 per cent to the close of trade yesterday. Today will erase some of those gains, and regardless, we obviously are yet to regain that 2007 peak. Those who sold out on the drops and have yet to buy back in have foregone that gain – and 2.5 years of dividends (with yields as high as 6 – 8 per cent per year and higher, depending on the company).
The high point of October 2007 was probably a time of unrealistic optimism – and the low point, some 17 months later, was likely an over-reaction to the down side. The combined future profits of all of the companies on the ASX 200 did not fall by 55 per cent in just over a year. They equally did not improve by 37 per cent since then.
The market works
In a perverse way, these swings and roundabouts – while stomach-churning – show the market reality in stark relief. Sudden drops and gains expose the herd mentality for all to see.
It bears repeating – there was no single event overnight that led to a drop of between 4 and 5 per cent. That’s not to say the ongoing macro-economic challenges aren’t real. They are – we have soft consumer spending, governments deep in debt and central banks with little ammunition left in the locker.
The stock market is, at its core, not too far removed from other markets, including the local vegetable markets. When demand is high, prices rise; when demand slumps, so do prices. Bananas are ‘worth’ neither $2 nor $13 per kilogram – they’re not 6 times tastier, healthier or more filling today than they were when the prices were low.
You might suggest that drops of 5per cent are hardly the market ‘working’ – in terms of providing efficient, stable pricing. You’re right in that sense, but the markets do work in one important way.
The swinging moods of the crowd may well be unpredictable and challenging, but they provide opportunities for the patient investor to pick up a bargain when pessimism reigns.
Buying a share in a company does not give you a share of (only) this year’s profits. Share ownership offers you a proportional ownership in all of the future profits of the company in which you invest.
Don’t sell – or buy – blindly. Buy when the price represents great value, when compared to the likely future success of the company. Sell if the future is significantly dimmer than the current price suggests. But whatever you do, resist the urge to just run with crowd.
The father of value investing, Benjamin Graham, famously said:
“You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right”
The crowd is running hard in one direction today – and buying opportunities will almost certainly be on offer for the thoughtful, business-focussed investor.
Scott Phillips is The Motley Fool's feature columnist. The Motley Fool's purpose is to educate, amuse and enrich investors. BusinessDay readers can click here to request a new free Motley Fool report titled Read This Before The Market Crashes.