To be frightened when the stock market falls as far and quickly as in the last three weeks is perfectly normal.
It takes a lot of faith to invest hard-earned money in something as ephemeral and abstract as equity or an ETF. If you’re going to invest your money, you’re going to put it in a brokerage account where it’s going to be displayed on a computer screen.
And now, in just a few days, a significant portion of it has been destroyed. In light of this information, it is completely understandable if your primal brain decides to abandon the stock market.
Assuming the question is about long-term savings, it’s probably a bad idea. People tend to move money out of stocks when the market drops sharply, but they often fail to reenter the market quickly enough when it has finally bottomed out.
Investing in stocks doesn’t have to be a death sentence. It’s a psychological ploy to help you cope with the dreadful days when your 401(k) account value plummets. When you invest in the stock market, you’re essentially buying a piece of paper with a predetermined value.
Purchasing stock entitles you to a long-term claim on a tiny fraction of a company’s future profits. It’s like buying a piece of the future profits of the world’s largest corporations by investing in an ETF or broad index mutual fund.
Profits will be delivered to your bank account in a variety of ways. Dividends are one way of receiving some of this money. Some of the funds will be kept on hand by the company or used to repurchase stock, resulting in an increase in the stock price. Some of the profits will be reinvested by the company’s executives in an effort to boost growth.
In a decade or two, we may not know exactly how much money large corporations will make, what technologies and business strategies they will employ to do so, or which companies will make up more or less of that total than they do now. Coronavirus outbreaks are unpredictable, and we don’t know how long they’ll last, or how they’ll impact short-term business performance in the United States.
However, if you take a broad view of history, one thing becomes abundantly clear: As the global economy expands, wages tend to rise. Even if a long-term forecast is accurate, the price an investor must pay to get a piece of those profits can swing wildly. And this has never been truer than it has been in the last week and a half.
Robert Shiller, a Yale economist and Nobel laureate, stated that “earnings have been hugging a trend” since 1950. In general, the market is more volatile than the company’s earnings. As a result, there’s more going on here than just estimating future profits.
And that something is the financial market cycle of exuberant optimism and paralyzing fear.
At any given time, there are a number of variables that determine which condition is applicable. It’s primarily a psychological issue (are people more greedy or fearful at the moment?). High-level economics (is the global savings glut or shortage?), with some financial market mechanics (are big hedge funds forced to sell shares to meet other financial obligations?).
When the value of your accumulated savings is decreasing, it’s frightening when sentiment shifts from optimism to fear, as it has in the last few weeks. However, it also means that the value of any future earnings has increased.
The price-earnings ratio is a common way for stock analysts to think about valuations, but it can be helpful to invert it. On Feb. 19, for example, this earnings-price ratio was 3.1% for the S&P 500, which meant that for every $100 invested in an S&P index fund, it bought interests in companies that made $3.10 in profits in the previous year.
As of Thursday, that number had risen to 4.2 percent — last year’s earnings were unchanged, but it was much more affordable to buy a share. Longer-term Treasury bond yields, on the other hand, fell dramatically during the same time period. On the 19th of February, a 10-year bond paid 1.43 percent and closed at 0.45 percent on Thursday.
Now, compared to just three weeks ago, you’ll be earning an extra 3.8% annually if you put your money into the stock market over the bond market.
You might say, “Have you thought about it?” A recession, widespread bankruptcies, and economic upheaval are all possibilities in these tense times.
All of this is true. Those additional 3.8 percentage points, on the other hand, are your reward for maintaining a steady course and keeping an eye on the long term — and for being ready to weather whatever storms the next year or two may bring.
It’s not a problem that stocks are so volatile right now — it’s a feature! Because of these periods of fear, stocks trade at levels that are closer to those of bonds or cash than stocks. Investors can think of higher long-term returns as a reward for putting up with volatility, which is known as the “equity risk premium.”
It’s a good reason to avoid investing in short-term funds. If you’re saving for a down payment on a house or car, it’s probably not a good idea to put your money in stocks, which lost 10% of its value on Thursday.
However, if you’re saving for retirement or some other long-term goal, it’s best to pick an asset allocation strategy that’s appropriate for your risk tolerance and stick to it. Consider the recent sell-off as an opportunity, rather than a cause for alarm.