The financial markets have taken us all for quite a ride in the past few months, particularly for those retirees living on fixed incomes. It’s not just the drop in prices. It’s the volatility that makes us feel queasy. What do most people do when they’re feeling queasy? Simple. Head for a safe haven.
Beware of Fear & Greed
Heading for a safe haven is – precisely – the wrong thing to do. Here’s why. When markets fluctuate as they have in recent months, it is nearly impossible to divorce yourself from the deep-seated emotional reaction of fear and greed – the two classic drivers of investor behaviour.
In the immortal words of investment guru Peter Lynch: “What makes stocks valuable in the long run is not the market. It is the profitability of the companies you own.”
An astute financial journalist called Neil Irwin published an insightful article in The New York Times about falling and volatile markets. Mr. Irwin was writing in March of 2020, but many of his comments are equally relevant now:
When the stock market falls as far and as fast as it has in the last three weeks, it is perfectly natural to be terrified. It requires a leap of faith just to place hard-won savings in such an abstract, ephemeral thing as a share of stock or an exchange-traded fund. Instead of spending on something concrete that can be enjoyed immediately, investing means putting money into what is, ultimately, a notation in a brokerage account displayed on a computer screen.
Although Mr. Irwin’s observations were about falling markets, his underlying observations could be applied equally to markets that fall, rise, fall, then rise again:
- We all entertain primal fears about sudden losses and apparently irrational gains.
- The desire to move money out of losing stocks is natural.
- But if you do that, you can fail to jump back in quickly enough when the market finally bottoms out.
What Are You Doing When You Buy a Stock?
Mr. Irwin offers a detailed, and invaluable, breakdown of what we’re really doing when we buy a stock:
When you buy a share of stock, you are buying a claim on an infinitesimal portion of the profits of that company for the rest of time. When you buy a broad index mutual fund or E.T.F., you are essentially buying a share of the future profits of all major corporations. The way those profits will be delivered to your pocket will vary. Some of it will be paid directly to you in the form of a dividend. Some will be held by the company or used to buy back shares, which materializes in the form of a higher stock price. And some will be reinvested by the company’s managers to drive growth.
What Happens When Optimism Shifts to Fear?
We would like to share the following four observations that we are confident you will agree with:
- Earnings tend to rise over time, as the world economy grows.
- The price we pay to get a slice of those earnings can swing wildly.
- When accumulated assets decline in value suddenly, optimism shifts to fear.
- Fear makes us seek shelter, which precipitates selling.
Mr. Irwin makes a huge, frequently overlooked, and profoundly contrarian observation: “The moments when sentiment shifts from optimism to fear are scary when you have an accumulated pile of savings declining in value. But it also means that the value you’re getting on any future earnings has increased.”
Let’s Talk About Equity Risk Premium
There’s something out there called equity risk premium, defined as the extra return that investors expect to receive in the long run by investing in a diversified basket of stocks.
Wrote Kerry Pechter in Forbes: “On average, since the Great Depression, stocks have delivered an attractive average (or equity) risk premium. That’s why people buy them and hold them for a long time, even though stocks are riskier (more prone to price fluctuations in the short run) than bonds.”
Conclusion: You Get Higher Long-term Returns as Compensation for Tolerating Volatility
As Mr. Irwin states: “The fact that stocks are extraordinarily volatile right now, in that sense, isn’t a problem with stock investing – it’s a feature!”
What we all have to do is think of the sell-off as the kind of episode that isn’t so much something to fear, but a moment of opportunity – however unnerving it seems.
Never forget that falling prices mean better deals. Still not sure? Reach out to our team for personal guidance.