We know that our parents are interested in growing their money, especially to help take care of their children’s education and needs. The recent stock market ups and downs likely have a lot of us worried about our investments. We asked Daniel G. Mazzola, CFA, CPA, to write a guest post to share his insight into recent events and the basics of investing and the stock market for our parents.
Panic vs. Patience
Recently I met a fellow investment advisor who described October’s stock market decline as a “buying opportunity”, adding “I love when this happens”.
I doubt whether the typical investor shares his enthusiasm. A few bad weeks erased nearly a year’s worth of portfolio gains. I myself will discard October’s monthly statement in the trash without so much as a brief glance at the bottom line valuation.
The stock market is driven primarily by three factors: corporate earnings, interest rates and investor psychology. An appreciation of these factors may help us cope with inevitable downturns in the future.
A better-than-expected GDP report and roundup of corporate earnings reports for the 3rd quarter 2018 confirmed the continued strength of the U.S. economy. Earnings are running ahead of analyst estimates and are on pace to be 22.5% higher than 2017’s 3rd quarter profits. The U.S. economy is healthy, unemployment is at its lowest levels in decades and a rising stock market is a product of our prosperity.
What is not favorable for the stock market is rising interest rates. Interest rates are the cost one party pays for the use of another’s money. Increasing interest rates make it more expensive to borrow money, so individuals reduce spending on discretionary items while businesses curtail plans for hiring, building inventory and expanding operations. Additionally, higher interest rates make less risky investments more attractive. Why invest in stocks when one can earn attractive returns on CDs and money market funds?
The psychology of the stock market and its investors has been described as “irrational and excessive in its swings”. What is positive one day is negative the next. The 24 hour-a-day news cycle and internet access to brokerage accounts influence investors to buy when things are going well and to sell when things are going poorly, the opposite of what they should be doing.
After reaching an intra-day high of 26,951 on October 3rd, the Dow Jones Industrial Average fell to 24,122 on October 29th, a drop of 2829 points which qualifies as a “correction”, a loss of 10% or more in Wall St. jargon. What happened to change investor sentiment so dramatically? The threat of higher tariffs and a trade war with China are certainly reasons to be worried. The upcoming mid-term elections, with possible changes in tax and public policy, is another cause for concern. Investor perspective is always in flux, and was negative for a good part of October.
It is important to realize that stock market corrections typically occur once every other year. The infrequency of corrections is a small comfort to those with short term time horizons or who do not have cash to deploy when opportunities arise. Nevertheless, horrifying short term downturns are the price to pay for average long term annual returns in the stock market of roughly 8%. While it would be less stressful if the market realized gains in an orderly and consistent manner, more often than not it is either boom or bust.