In recent days, we’ve seen turmoil hit the stock market. As I’ve written before, stock markets are completely transparent and a number exists (the index value) that fluctuates on a daily basis which shows its current value. I’ve also mentioned before that the media loves to draw attention to drastic changes that happen in the stock market. It captures people’s attention, stirs our emotions and makes us act in a totally irrational fashion.
This is the reason why many individuals fail as investors. We think and act on emotions rather than on logic. It makes sense that the index never truly represents the actual value of the companies that make up the stock market. There is always the element of investor sentiment that is captured in the value of the stock index. How do you measure the value of emotions? It’s impossible to know.
The Herd Mentality
Over the last two weeks the Chinese stock market made front page news on a daily basis. Who would have thought that a market that rose so fast, could drop so soon. I’m sure the negative detractors and the doomsayers were out in full force to tell you “I told you so.” A large part of the problem that surrounded the rise and fall of the Chinese stock market is that consumer investors like to follow the crowd. When things are up, people rush in like Black Friday sales in America . When things are not, you get people rushing out the door like a big fire just started in a building.
Prior to even getting to this current point, many people fail to realize just how fast the stock market in China had risen over the past year.
If you look at the Shanghai Index in China, the market as a whole had risen over 132% in over a 1 year period. Over that same period, the S&P 500 had only gained around 10%. You can see why the Chinese stock market had entered into bubble territory. The fact is though, people didn’t care. When the market was rising daily, everyone rushed in like a bunch of sheep waiting to get slaughtered.
It’s known as one of the seven sins for a reason, but that doesn’t prevent individuals from doing it even they might know that it’s wrong. Greed is generally the reason why we, as people, do things that put ourselves into financial risk. When everyone around us is making easy money, we are always tempted to do the same thing and try to get a piece of the pie as well. If my friend and my neighbour are making easy money, why shouldn’t I be doing the same too? It’s only fair. Right?
With the rising market, greed is what put Chinese investors into a big hole. Individuals started to borrow money to invest in the stock market with little heed to risk. Since the market was always rising, people didn’t even believe that there was risk in borrowing money. The only thing that people cared about was how fast they were making money by using money that they didn’t really have. When you let your emotions get the better of you, or worse, you let greed get the better of you. Then your actions don’t reflect what logically wouldn’t make any sense.
“It always goes up”! “It’s different this time”. “Everyone else is doing it”. Those are always common phrases that you hear people say when it comes to emotionally making a decision. The real question that people should be asking themselves is “Does the market justify a 132% run up when the economy has only grown 5% this year?” Someone thinking along those lines will definitely see the risk of investing in a market that has already risen so much in a year, rather than trying to be greedy and catch it going even higher with borrowed money.
What happens on the opposite end of the spectrum when stock markets fall? When fear grips a stock market you get spectacular crashes. All it really takes is one catalyst to start the trend of reversing fortunes.
It only took 1 month for the Chinese stock market to fall over 30%. Just like people herding into to buy, when the market starts to fall, people start running for the exits. Fear starts to grip our emotions and just like everyone else we start selling everything in sight. When the market started falling over 5% on a daily basis, people scrambled as fast as they could to sell. Those that borrowed money to buy stocks were in an even deeper hole as not only did they still need to repay their debt, but they had also suffered actual capital losses as well.
Even for the most savvy of investors, the sight of seeing your equity lose money is always an unsettling feeling. All those “what if” scenarios start popping in your head and then inevitably we take the drastic action of selling all our investments. Someone who thinks rationally before selling their entire portfolio should really be asking the questions. “Are the results of my portfolio justified?” “Is what’s happening in the marketplace sustainable?”
Rationalizing Your Thoughts
A lot of people compare the Chinese market to what happened in North America in 2008. There are huge differences between the Chinese market and the US market. For instance, the Chinese stock market had risen an astonishing 132% in 1 year. For the S&P 500 index it took well over 5 years to even reach that kind of gain.
Secondly the Chinese stock market was being driven higher and higher by new companies that listed on the market to raise capital but didn’t even have viable business plans. This was much more similar to the year 2000 dot-com bubble that plagued the US markets than the results of 2008. Just to take things into perspective. If you look at the graph from the low point in 2002, You’ll see that the S&P markets has only risen 140% from that point to now. That’s 13 years of gains.
Compounded year over year for the 13 years, that’s only a measly rise of 2.7% in capital gains. Add that to the average dividend yield of around 2% and you’ll get returns of 4.7% a year. Over that 13 year span, we can reflect and say that yes, we experienced fairly slow growth. A 4.7% return per year seems entirely reasonable.
On top of that, the S&P represents the 500 largest companies in the United States. These are companies that supply everything from gas, electricity, food, water and clothing. All of these are essentials to your day-to-day living. In a sense, it can be seen why the markets rebounded so fast from 2008. These companies weren’t going anywhere. People still need to buy their everyday essentials.
Stick To Your Goals
Regardless of whatever the market conditions are, the key to becoming a successful investor is being able to stick to your goals. One needs to build a global diversified portfolio and stick to the weightings that you initially set out for yourself. If one region of the world does better than the other, avoid trying to chase gains by putting more money into that region. Stick with your original asset allocations.
A successful investment portfolio only takes a little bit of management and that’s it. There is no need to continually trade on the ups and downs. Avoid the media hype that you see on front page websites or newspapers that may persuade you to take action when it’s not warranted. Those stories will just arouse your emotions and may cause you to do irrational things to your investment portfolio.
If you do all these things and continue to balance your portfolio, all of the geopolitical events that happen periodically will just become noise in the long run.