Investing is a scary prospect, and most of us don’t invest in the stock market or if we do, we invest poorly. Market upturns, and market downturns leave many investors hopeless for various reasons. If we need our money to grow to help us when we retire, and because of COVID or market uncertainty our portfolio values (which is the amount of money we have in our investments) have declined, then we find that income levels which rely on the value of our portfolio may have also declined. This leaves us confused as to what to do about it. So, we educate ourselves and find that we are bombarded with tons of information from various sources. Much of the information and explanations comes from industry experts using terms we have never heard before. My question is how should you know what to do if you don’t even understand what the problem is in the first place?
While it is impossible
to control what happens in markets, you may be able to make sense of events by
gaining a better understanding of relevant investment terms.
In the hope of
assisting investors to make better sense of the myriad of terms being used, we
have taken the following from Debra Slabber, Business Development Manager of
Morningstar Investment Management South Africa, and we have highlighted a few
financial terms that are often used during market downturns.
Recession
The term “recession” in
its strictest definition means that an economy experiences two consecutive
quarters of negative economic growth because of a significant decline in
general economic activity.
During a recession,
businesses experience less demand (i.e. they sell fewer products and/or
services). These businesses then usually react to this by cutting costs and
sometimes laying off staff (retrenched) to protect the bottom line and
profitability of the business. When staff are retrenched, this leads to higher
unemployment rates.
“Generally, a recession
does not last as long as an expansion does. Historically, the average recession
(globally) lasted 15 months, compared to the average expansion that lasted 48
months.
Causes of a recession
can vary. While COVID-19 has certainly put a drag on the global economy, it
remains to be seen whether it will have lasting effects on economic output. It
is important to realise that recessions are a normal part of an economic cycle
and every person will experience a few in their lifetime,” says Slabber.
Bear Market
A bear market is when a
market experiences a decline of at least 20%, usually over a two-month period
or longer. Bear markets often arise from negative investor sentiment because
the economy is slowing or due to the expectation that it will slow down. Signs
of a slowing economy may include a decrease in productivity, a rise in
unemployment, a decrease in company profits and lower disposable income. When
someone talks about having a “bearish” view, it means they have a pessimistic
outlook.
Slabber points out that
while a recession and a bear market often go hand in hand they are associated
with different issues. The distinction between a bear market and a recession is
that a recession is measured by a decline in economic output (also known as
gross domestic product or GDP), whereas a bear market is identified by a
decline in stock market values in excess of 20% over a prolonged period as a
result of negative investor sentiment.
Some other terms that
you might come across when reading up on market downturns include:
- A pullback, which is a short-term price
decline within a longer-term trend of price increases.
- A correction, which is when an asset's
price falls by at least 10%.
- A market crash, which is a drastic market
decline over a short period.
- A depression, which is a long-term
recession that can last multiple years.
Volatility
Markets have been
highly volatile of late, meaning equity prices have bounced up and down rather
severely from one day to the next. Volatility marks how much an investment's
price rises or falls. If an investment's price changes more dramatically and/or
more often, it's considered more volatile.
Price volatility is
usually expressed in terms of standard deviation, or how much an investment's
price has fluctuated around its average price over a certain period. A higher
standard deviation implies an investment's price is more volatile.
“Investments with more
uncertain outlooks, like equities, are typically more volatile,” says Slabber.
“That is because equity returns are based on a company’s profitability, which
is difficult to predict. In uncertain market environments, like the current
one, investors tend to be especially pessimistic about how businesses will
perform, which can result in steep market declines.”
So, why would you want
to invest in a more volatile investment? Because you are likely to be rewarded
with a higher return over the long-term.
Risk
Volatility and risk are
terms often used interchangeably, although they are very different. Risk should
be defined as “permanent capital loss” or the chance that you won’t meet your
financial goal.
For a retiree, one risk
might be not taking on enough risk. By reducing your exposure to more volatile
or "risky" assets such as equities, you could significantly limit
your portfolio's potential return over the long run. By remaining in cash for
prolonged periods of time you run the risk of increasing your tax bill
significantly (due to interest earned being fully taxable) or losing purchasing
power due to the eroding effects of inflation.
Slabber explains that
even though a more equity orientated portfolio will experience more volatility
in environments like what we are facing now, your asset allocation might not be
overly risky. “If you're far away from retirement, you have time to ride out
your portfolio's short-term volatility and take advantage of longer-term gains
that equity markets will generate,” she says.
Loss Aversion
Loss aversion is the
theory that investors feel more pain when they lose a certain amount of money
than they feel pleasure when they gain an equal sum. In other words, you would
feel more discomfort from losing R1,000 than pleasure from gaining R1,000.
Time and time again it
has been proven that selling your investments in a downturn and giving up on
your long-term financial plan is detrimental to a successful investment
outcome.
So where does that
leave investors?
Things might not be so
hopeless after all.
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