Certainly this week has a lot of people worried. With oil prices falling and China’s economy causing stocks to go into free fall, many people may be thinking of exiting the markets and waiting for calmer waters. Is this a good time to get out before more damage is done?
To answer that question, consider some facts:
- No one has any idea what the market will do from here on.
- The market is priced based on what people think stocks will be worth in the future, with a little bit of fear (in down markets) or greed (in up markets) added on top.
- As long as people keep inventing tools and methods to be more productive, stocks will trend up over time.
The first fact says that no one – not you, not a Wall Street trader, not the president of Merrill Lynch knows what the market will do tomorrow after the first trade. They might be able to predict an up or down move at the opening based on news that comes out after the markets close, but they can’t take advantage of that because the person on the other side of the trade would have the same information. It will open up or down. Will stocks continue to fall? Who knows? Will they rally to new highs? Who knows. All we know is that they are cheaper than they were at the start of the year. Many people like to speculate on what markets will do, but they really have no better idea of what will happen than you do.
The second fact says that the price of stocks is always going to include all of the information that is currently out there. It would be different if news traveled slowly, but today something that happens in China is known in Los Angeles within a few seconds or less. News travels at the speed of light, and very soon after the news breaks, the markets react. If you know that bad news has come out, it is too late to sell your shares because anyone who wants to buy them will pay you less than before since they know the same news.
The third fact says that if you hold a group of stocks for a long period of time, they will go up in price. As people come out with better computer software, allowing the same number of people to make twice as many products per day, the amount of wealth the company can create increases so the price goes up. As people find better ways to build things, the amount of income increases so the price of the stock goes up. There are always random fluctuations in the price of a stock due to emotions and other factors, but the general trend of the market is always up. That continues until society falls apart for some reason, at which point, the value of your portfolio will be the least of your worries.
Given these facts, you reaction after a market drop should be the same as it is on any other day:
- If you are a long ways away from needing the money (five years or more), you should hold on and wait for the recovery. In fact, you should continue to add cash to your portfolio and acquire shares at the new lower prices. By buying more shares as the prices decline, you’ll be that much better off when prices recover and continue higher. You don’t know exactly when prices will rise, but because stocks naturally trend higher over time, you know that they will.
- If you are getting close to the time you’ll need the money, you should be cutting your positions, raising cash and shifting money into fixed income assets like bonds and utility stocks. The return on stocks over short periods of time is unpredictable, so you need to shift into assets with less volatility (or no volatility at all like bank CDs).
If you have a long time to go, but you get worried during market drops, there is nothing wrong with ignoring your stocks for a while. While prices may go lower, to sell now might be locking the barn after the horses are already stolen. You might miss out on a big rally.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.