What should investors do when markets turn sour? The co-founders of the Sharesies online investing platform give their view.
Many investors, particularly new ones, spend a lot of time worrying about the prospect of a downturn. But guess what? A downturn in the market isn’t always a bad thing when you’re an investor. If you know what to do when a downturn comes, you can actually use these periods to your advantage. Part of investing in assets like shares and managed funds is accepting that you’ll see your investments go up and down in value from time to time.
Don’t be too worried about that. If you don’t want to accept more risk, stick your money in a bank account. But if you want to try for a better return than bank deposit rates, that means you have to ride out some movement. When you know why you’ve invested, and what your strategy is, you can have the confidence to stick with it and make the most of the opportunities that arise in challenging times. Besides, there are lots of people who have made their money in a market downturn.
Over the last 50 years, there’s been a serious downturn in the market roughly every 10 years or so. It’s normal, and just the market doing its thing. Sometimes, you’ll hear this talked about as a transition from a “bull market” to a “bear market”, as was the case in March 2020, when a very long run of higher returns came to a halt as the Covid-19 pandemic spread around the world. (One definition of a bear market is when prices drop at least 20 per cent from their height.)
The Great Depression (the big sharemarket crash ending the excesses of the roaring 1920s), the 1987 Black Monday crash (the famous end of the champagne culture of the 1980s), the dot-com bubble (caused by excessive speculation in internet companies in the late 1990s), and, of course, the GFC (the global financial crisis between mid-2007 and early 2009) are just a handful of the many ups and downs we’ve seen.
What you’ll notice from them all is that generally prices went on to not just recover but actually exceed their previous highs. People talk about a market “correction” when prices drop more than 10 per cent from their previous peak. You can expect to see this every 12 to 18 months or so. A crash is more extreme – it’s a correction that happens really dramatically over a short period of time across a lot of the market.
Crashes can be caused by a variety of reasons triggering heightened emotions such as fear and panic, as people face economic factors they aren’t sure how to deal with. The worry can be contagious and spread among other traders, which makes the crash worse. When you look back through history, you can see long periods of one-way growth, rising share prices and house prices, risky speculation by traders, banks handing out home loans whether people could afford them or not, and international political swings and roundabouts.
This is often followed by a recession, a period of temporary economic decline identified by a fall in GDP (gross domestic product) in two successive quarters, and a shrinking economy. Boom turns to bust – but then, in time, the boom returns.
Bargain prices
The first time you see your portfolio balance drop can be pretty scary. No one likes to lose money. The most important thing to do is to remember not to fret. Unless you’ve borrowed lots of money to get into your investments and you need to sell in the very near future, a market downturn shouldn’t be too much of a worry. There is also help on hand if you’re keen for some extra reassurance for what’s right for your situation, through an independent financial adviser. To get the upwards momentum you want to see carry your investment portfolio to future gains, you need to be prepared to see some of that downwards movement too.
Quickly give yourself a financial check-up – do you desperately need the money from your investments right now? If you don’t and you can afford to hang in there, it’s worth seeing if you can ride the downturn out. But hanging in there isn’t all that you can do. If you are prepared, you can take advantage of a downturn too.
After all, if you were at the supermarket and saw that some of your favourite cereal was heavily reduced in price, you’d probably stock up, right? The same theory applies in a market downturn. When prices drop, shares can be viewed as being “on sale”. If you still believe in the companies or the funds you are thinking about investing in, the market may be giving you an opportunity to jump in at a bargain price. When you do, you’re in a great place to ride the eventual upturn.
Many people who have done very well out of their sharemarket investments were able to buy at the point when others were getting out. Loading up then gives them an even bigger portfolio to make the most of an eventual upswing in value.
Paul Brownsey, head of investment strategy at fund manager Pathfinder Asset Management, recommends people “take a deep breath and go for a walk” when they see something happening on the markets that they don’t like. “See for yourself that out in the real world, companies are still doing their thing. Construction companies are still building. Electricity-generating companies are still generating electricity. Supermarkets are still selling food. Telecommunications companies are still charging you a monthly fee to use your phone. Most people are still paying their Netflix subscriptions. Just because sharemarkets are down, it doesn’t mean your investment will end up at zero.”
He suggested people might think about it as if they were looking to buy a new iPhone for $1000. “You go back to the store today and it now costs $800. How do you react? Mostly by saying, ‘Awesome, I just saved $200!’ What if you were looking to invest $1000 into Apple shares last week. If those same shares now cost only $800, shouldn’t your reaction be the same? It’s still a very good company. If it’s still making a similar amount of money as it was before, it must be better value now.
“If you have extra money to invest, down markets are good. You’ll get better long-term returns when you invest at lower levels.”
Rainy day fund
So how can you manage yourself during a downturn? There are some things you can do to feel a bit better about your financial situation if you decide to ride it out. Build up your other reserves, particularly your emergency fund. An emergency fund is just what it sounds like – money set aside for emergencies, such as getting sick for a long time or losing a job. It doesn’t need to be a lot, just enough so you can get by without any income for a while. A good rule of thumb is to have three to six months’ worth of income for your emergency fund, but be realistic about what is achievable, too.
Having this money set aside is a great psychological boost during times when your investments aren’t performing well. And if you get stuck with an unexpected expense, you won’t be forced to sell your investments at a bad time. Pick an amount that works for your budget and that you can regularly set aside. Build up your emergency fund to a level that covers your needs.
Don’t let saving for retirement fall by the wayside. Keep contributing as long as you can. If you don’t need your retirement money for a long time, try to resist the urge to move your money to a more conservative fund. People who do this tend to lock in the losses they’ve suffered, which could leave them a lot worse off at retirement.
You can measure your investment progress by looking at the number of shares (or part of a share) you own in various companies, or the number of units in funds, rather than the price of those shares or units. This will show you how well the downturn is setting you up for future success. Assuming that your investments perform well, a higher number of shares or units has the potential to result in a higher return when they rebound. It’s likely that during periods of market weakness, if you continue to invest, the number of shares you own will increase more quickly (as you’re buying them at a cheaper price).
The quickest way out of a downturn or recession is for consumer confidence to pick up. You can do your bit by voting with your spending dollar, as well as your investing dollar, and doing business with the companies you want to see succeed.
Less is usually more when it comes to monitoring your investments during a downturn. Markets have gone through downturns before, and have always found a way to bounce back over the long term. If your portfolio is invested in line with your strategy in good times, and you still believe the companies or investments are sound and your personal circumstances haven’t changed, then stick to the plan in the tough times, too. If you no longer believe that the reasons behind why you made an investment stand true in the current environment and in your view of the future, you might want to recalibrate your portfolio.
But watch out for loss aversion (being more willing to take risks to avoid a loss, than to make a gain). If you need a break from constantly checking your investments, you might want to set up auto-invest instead. It’s a simple way to put into place the practice of dollar-cost averaging, where you regularly invest a particular amount regardless of the share price. You can set it up so your money goes out of your bank account and into the funds you want without you having to do anything. You’ll thank yourself for this in future if the price picks up again.
Don’t let your debt get away from you. Get rid of any high-interest debt as quickly as you can if the wider economy is going through a soft patch. If you have a mortgage, make keeping up with the repayments a priority. The people who do best in a downturn are those in a strong financial position who can take advantage of opportunities.
Beating Inflation
Inflation is an important thing to get your head around when you’re investing. Basically, inflation refers to prices increasing. It’s something that central banks keep an eye on when they are setting official cash rates. The big problem with inflation is that the money you already have becomes worth less because its buying power drops. That’s a problem for people who like to keep their money somewhere with a relatively low rate of return. In a bank account with a low interest rate, for example, you could actually end up with the purchasing power of your money going backwards.
There are only two ways to fight inflation: by spending your money on something useful, like rent, groceries or petrol (or lollies), or by investing it, putting it to work for you, and getting a return that beats inflation. Otherwise, it slowly but surely fades away.
Central banks like inflation to sit at a rate of about 2 per cent a year. If every year, prices go up by around 2 per cent, your money becomes 2 per cent less valuable. The things that cost a dollar a year ago would cost $1.02 now. Like all percentages, the increase compounds – so inflation adds up faster than you’d think.
This might change the way you think about investing. Lots of low-risk bank accounts pay interest rates of between 1 and 3 per cent. On the face of it, this might seem OK – 3 per cent isn’t very high, but on the other hand, it’s very low risk (and remember to check out risks and fees related to the specific amount you’re looking at). But you need to subtract inflation from your returns to get your real (inflation-adjusted) returns. If inflation is 2 per cent, and you make a 3 per cent return, then your actual returns are a measly 1 per cent. Yikes.
And if you make a 1 per cent return with 2 per cent inflation, you’re actually going backwards by 1 per cent. On paper it looks like you gained money, but in real terms you actually lost money. Remember, 2 per cent is just used as an example, and it’s possible for inflation to run much higher than that.
If you have a long time horizon, one strategy of addressing the risks of inflation would be to invest in higher-risk growth assets, like shares. There are a couple of reasons for this:
- Over a long time horizon, shares tend to grow in value, on average (depending on the investment). They may be up and down year to year, but average returns usually look pretty good. So even when you adjust for inflation, you can still walk away with a pretty solid return.
- Inflation is about the money you spend right now. If a bottle of milk is more expensive now than it was a year ago, that affects you only if you’re buying the bottle of milk. Any money you have invested for the long term is essentially “protected” from inflation until you sell and want to use the money.
This second point means that inflation is a great motivation to stay strong if things go down. Let’s say you’ve had some money invested for a year, and it loses 2 per cent of its value and inflation is 2 per cent. If you sell, you’re actually locking in a 4 per cent loss. That’s twice as much as it looks like you lost. But if you hang in there, you can hide from inflation until your returns turn things around. If you end up with a 7 per cent average return per year, and inflation was an average of 2 per cent, you’re still getting 5 per cent. That’s really solid.
Since inflation tends to average on the low side over time, and long-term returns on shares tend to be on the higher side, the longer you stay invested, the more likely you’ll beat inflation. And that’s on top of any of the great returns you may get anyway.
Extracted from The Sharesies Guide to Investing: Your roadmap to financial freedom by Brooke Roberts, Leighton Roberts and Sonya Williams. RRP $36.99. Out now. Published by Allen & Unwin NZ.