What gives stock markets a cold?

What Gives Stock Markets a Cold?

It seems like we are having one of those stock market wobbles which corresponds with the major news story of the day. 

It got me thinking about one of the things which I used to find difficult to get my head around with investing.  Why it is that sometimes bad news in the media can be seen in short term portfolio movements and when we go looking for it on other occasions it is so hard to see?

An explanation can be found in the efficiency of markets.

Coronavirus has been in the news for weeks now and looking at the chart below of global equities for the past six months, one can struggle to point out the exact days around the discovery of the virus from the chart alone.  Yet the drawdowns of the past few days stand out like a sore thumb, why could this be?

It turns out markets are super-efficient at absorbing information into stock prices.  The stock price at any moment reflects the collective view of all market participants on the fortunes of each company, taking into account all available information.  It turns out they are pretty good at it too, which is actually not that surprising when you consider the amount of trades placed and volume of stock which changes hands every minute of every day.  Volumes on the London Stock Exchange alone for 27^th February were 1,432,183 trades with a turnover of £6,964,344,006.  Little wonder why at bdb we are very cynical of any claims of an ability to beat the market given this immense weight of collective intelligence.

The market is moved when something new and unexpected comes to the fore which is different to what the market had already priced in.  The bigger and more impactful the new information, the more the market moves.  In this instance it is a realisation that the economic effects of this virus had not been properly priced in due to a lack of understanding or information.  Perhaps it is still not all priced in, we will only know in the coming days and weeks as the story unfolds.

So what can you do about all of this?  Sadly not a lot, the trouble is, the absorption of information into prices happens so quickly that no one can position themselves ahead of time to benefit from the effect of these short term rises and falls.  Not without the help of a crystal ball anyway.

So what happens next?

The honest answer is nobody knows, it could continue to fall from here as more is learned and fresh bad news is absorbed into prices.  It could rally and recover in a day, should something emerge which suggests market participants are overreacting.

One thing I am prepared to predict is that in ten years, the compounding effects of long term returns on a properly constructed portfolio will be such that this week’s wobble will appear as a blip in the rear view mirror on the chart of your portfolio return. 

Whatever happens with coronavirus, capitalism remains the most successful economic model yet invented.  Capital markets, where ideas meet financial backing, will continue to exist and no one has yet suggested that this virus effects peoples’ ability to have great ideas.  Investing in stocks is a way in which we can all benefit from the success of these ideas and have our risk efficiently rewarded.

Some remedies for the days ahead

Many reading this will have heard these from us so many times but I thought it might be a helpful reminder to restate some of the key messages that come from our scientific approach to investment:

• Don’t just do something, stand there! – Reacting to short term emotion by intervening in your long term investment portfolio is one of the biggest destroyers of wealth. Human behaviour driven by fear and greed is the reason why time and again there is such a difference between what markets deliver and what investors receive.
• The FTSE is not your portfolio - When reading about “markets plunging” as measured by the FTSE or S&P, remember that you have a well-diversified portfolio of stocks and bonds for times just like these.  The bonds have done a fantastic job of reducing the downturns of the past few days.
• Focus on the long term – Short term volatility is the price you pay for long term returns.
• Concentrate on what you can control – You have no power to influence capital markets, but you can control which risks you take, what costs you pay and how you react.
• If the news is worrying you, switch it off! – Economic reporting and news is no more than a lesson in history.  It offers little of value in terms of helping you make effective decisions for your financial future or your chances of investing success.
• Risk and return are related – Without risk we can’t get the inflation beating returns that we all need.  In investing terms, that will mean short term downturns such as these.
• It is time in the market not timing the market which is important - Short term drawdowns are only damaging to your plan if you sell (either because you need to or your emotions compel you to do so).
• You have a plan! – A well designed financial plan should incorporate a short-term contingency.  It shelters the portfolio from bad timing (i.e. the need to withdraw corresponding with a short-term drawdown).  We call this improving risk capacity, which is one of the core elements of our three dimensional approach to risk profiling.

I hope that this piece will have helped a little with understanding why markets behave in the way that they do.  If you are worried about anything you hear or read and the effects on your portfolio or plan, get in touch, we’d love to talk about it with you.