Last week saw a dramatic drop in value of global stock market values (FTSE world Index fell 11%), but was this a crash or a correction?
• A crash is a sudden and very sharp drop in stock prices, often on a single day or week. Sometimes a market crash foretells a period of economic malaise, such as the 1929 crash when the market lost 46% ( Source: Macrotrends). in less than two months, kicking off the Great Depression. But that’s not always the case. In October 1987 (Black Monday) stocks plunged 22% in a single day(source: Investopedia), the worst decline ever, before recovering back over the next year. Crashes are rare, but they usually occur after a long-term uptrend in the market.
• A correction is often defined as a 10% drop in the market from recent highs. These happen more frequently the last being at the end of 2018 with fears over USA-China trade relations. Recoveries are quick – the FTSE World Index dropped 9% in 2018 but recovered and grew by 27% in 2019 ( source FTSE World Index FTWORLDSR)
Why the stock market value falls…
The market declines because investors are more motivated to sell than to buy. That’s simple supply and demand.
The market moves for many reasons, including because the economy is weakening, or based on investors’ perception or emotion, such as the fear of loss.
Investors are looking forward over a medium to long term (5 years plus). Whereas speculators watch for signs, including news, rumours and anything in between, of how the market will move. It moves for many reasons, including because the economy is weakening, or based on investors’ perceptions or emotions, such as the fear of loss, for example.
While the reasons for a one-day drop may vary, a longer-term decline is usually caused by one or several of the following reasons:
• A slowing or shrinking economy: This is a solid, “fundamental” reason for the market to decline. If the economy is slowing or entering a recession, or investors are expecting it to slow, companies will earn less, so investors bid down their stocks.
• Fear: In the stock market, the opposite of greed is fear. (And nothing is quite so good at stoking investors’ fears as a 24-hour news that talks about how much the markets are falling and If investors think the market is going to fall, they’ll stop buying shares, and sellers will have to lower their prices to find buyers.
• Political or Other Events: This miscellaneous category consists of everything else that might spook the market: wars, attacks, oil-supply shocks and other events that aren’t purely economic such as the Coronavirus.
These reasons often work together. For example, as the economy overheats, some investors see a slowdown in the future and want to sell before a stampede of investors flees the market. So, they sell, pushing stocks lower and dampening confidence. If the move down persists long enough, it may make investors fearful, sending stocks still lower.
At times like this it can be great to have someone by your side to steady your nerves, and that’s one thing a financial planner should do.
In the last four corrections since the 2008-09 global financial crisis, the average decline was 15.3% over three and a half months.
Bear markets tend to be longer still. In the three bear markets since 1987, the average decline has been 46.5% over 1.4 years.
In contrast, the last three bull markets have lasted nearly nine years on average. Downturns tend to be short-lived, especially relative to uptrends.
What happens to your portfolio in a market crash?
The FTSE 100 index is the usual benchmark in the UK investors reference when they talk about “the market,” as it comprises the largest publicly traded companies. But unless you’re invested exclusively in a FTSE index fund, your actual returns will differ from the market’s because you don’t own the same shares in the same proportions as the index.
Gauging how you’ll fare in a market crash or correction depends on the composition of your portfolio. The performance of individual shares tends to be more volatile than that of the market. If the FTSE 100 were to drop 10%, individual stocks in your portfolio could decline 5% or 15% or 30%. Some might even go up.
How can you prepare for a crash?
Knowing what’s happening when stocks are dropping is the first step in protecting yourself from the emotion and panic that accompany a financial loss. Now that you know what a market crash and a correction is how can you be prepared?
Well there are some golden rules to investing in the stock market:
• Have a medium to long term strategy – Make sure the goal you are investing for is at least 5 years away – any falls that happen such as the events last week then have time to recover.
• Always have a cash contingency fun – Look to hold at least 3 months expenditure in cash funds so you do not need to access stock market-based investments in the short term.
• Financial goals that require funds in the next 5 years should be financed from funds held in cash-based accounts – these are not then at risk of stock market falls.
• Stock market falls are often an opportunity to invest at a lower price – but remember you still need a 5-year strategy anything less is just speculating.
• Save on a regular basis – by doing this you can actually turn a stock market fall to your advantage – if the value of your pension or ISA fund falls your next contribution buys in at a cheaper rate and then potentially benefits when the fund price rises again.
• Don’t sell your investment when the markets have fallen – this is a sure way to make a loss. If you have followed the points above you should not have to sell.
Investment values and income from them can go down as well as up, investors may get back less than their original investment. Companion Financial Planning LLP is authorised and regulated by the Financial Conduct Authority; registration number 705850.
If you require any more information or help, let us know!