Since the huge drop in the middle of August, stock markets around the world have been filled with volatility and noises. If you have any investment accounts, including a retirement account like 401 (k), you probably have received some communication from your custodian, fund manager, or financial adviser in the past weeks about what this means to your finances. The majority of these messages are divided into these two categories:

#1: The market is doing what it’s supposed to do, which is go up and down. We anticipated this happening and it’s normal. If you are investing for the long-term, there is nothing to worry about. The value of investments most likely will rebound at some point in the future, and the market drop represents a good opportunity to invest more at a cheaper price.

(This answer likely came from strategic asset allocator / passive investors.)

#2: The market is going down. The good news is that we had anticipated the likelihood of it happening and took a more defensive position (such as increasing the amount of cash or bond holdings.) You paid us to protect your money and we’ve done so, therefore there is nothing to worry about. In fact, now we have the extra cash to reinvest in stocks when they are cheaper. We timed the market right and it worked!

(This answer likely came from managers practicing tactical asset allocation and/or active fund / stock selection.)

In essence, both of these responses gave the same answer to the question posted at the title. What should I do when the market keeps going down? NOTHING. You either have predicted it, done something about it before it happened, or you didn’t even think about it. Obviously, investors feel the need to DO SOMETHING whenever the market is not going up; however, they seldom get advice that selling is the right thing to do when the market is heading south.

Why is that?

We’d like to think that everything we own has a pre-determined value. However in real life, what really determines your asset value is how much you can sell it for. The stock market is the same. While the stocks you hold may represent a share of the company equity that you own, eventually you don’t get to touch that value until you can sell it at the price that they were valued at.

So what causes the stock market, or a particular stock price, to go down? It’s because the current investors no longer want to hold the shares and are willing to sell at a lower price than the previous transaction. And when does this happen? When there are more people who want to sell than those who want to buy.

You can easily picture now that if everyone thinks that the market is going to keep dropping and they’re trying to sell, the lower the market price will become and the market will keep falling. This is a classic example of a “self-fulfilling prophesy.” It’s not really about the underlying value or operation of the companies, or even the greater economy, it’s about investor’s confidence, and what they choose to do when they perceive that the market will keep going down.

You may wonder, “So if I have supernatural power to know that the market will lose half of its value in one month, I should still do nothing?” Actually, if you are 100% sure that it will happen, logically you may do the following:

#1: Sell your stocks

#2: Tell all of your friends, neighbors, and anyone who will listen to sell their stocks too. (And of course, after you’ve already sold yours.) Even better, get on national TV to tell people the stock market is going to tank and smart people should get out.

#3: Your warning takes effect and everyone now wants to sell, creating the downward momentum to further crash the market.

#4: In one month, your vision came true and the stock market lost half of its value. You are now perfectly poised to go in and purchase the stocks back at a much lower price. (And of course in this scenario, you may also have the superpower to know that it’s the lowest the market’s going to drop so you can look forward to an upward swing.)

#5: Having that knowledge, you have to tell everyone now it’s time to buy. With enough people listening to you (more buyers than sellers), the market starts to rebound.

#6: You have now officially predicted one market cycle and everyone will look to you for the next advice. It’s all because of your superpower to see the future though, not because you are smarter than the others.

One person may not have the power to move the market like that. But collectively, our prediction of the future brings the future into fruition. Therefore if you are able to foresee the future, maybe the best thing to do is NOT to be a Good Samaritan and keep the information to yourself.

You may also wonder, “What if the market keeps going up? Should I buy?” This is exactly what many people do during the market uptick, which further creates the overvaluation, or the “bubble”. If most of the investors perceive that the market will keep going up, they will be willing to pay a higher price that the sellers ask for. Eventually the market will get to a point where nobody is willing to sell, because they think the price will keep going up. There will be no market, and the return will come to zero.

Then what happens? Some early investors will start to think that since they are not making any more extra return as time goes by, it’s time to look for other investment options. And the market will eventually creep down from its peak, although not always a big one day drop that will catch your attention. Or it can come like a bang, like how much the Chinese stock market (Shanghai Composite Index) has dropped since its peak, as the chart below shows.

SHCOMP 5 -year 090915

Source: Bloomberg

 

It’s fitting to note then, as a summary, that if you had invested in the Chinese stock market a year ago, your one-year return is still a whopping 42%. And what if you were a long-term investor that has been investing bit by bit for the past 5 years, live in a cave and don’t watch the news? Your would have achieved a better annualized return than people getting in with the hype in the beginning of 2015.

So to the long-term investors out there, some market volatility is a good thing. Not everyone has the stomach for the ride, but you do, as the world fears and panics around you. That is what gives you the reward in the long-term. And maybe you can do something when the market is going down after all – continue investing like you have planned to.

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