I was talking with an investor recently about the latest stock market downturn. He was puzzled; if General Motors (GM) is supposedly such a great stock and vastly favored among portfolio managers, why would it fall 30% during a market correction?
That’s when I realized that if an experienced investor doesn’t know the answer, then perhaps it’s time to explain that phenomenon to a broader stock-investing audience.
Stock portfolio managers typically work at mutual funds and hedge funds. If they are bullish on the market and on stock valuations, they’re going to be close to fully invested, meaning that they’re not holding much cash in their portfolios.
Now, picture a scenario in which investors begin worrying—like we had between summer 2015 and January 2016—about oil prices, interest rates, China, bank liquidity, housing, jobs. I’m talking about worry, not about reality. There’s a HUGE difference between the two.
While investors are worrying, newscasters and investment writers realize that they can sell more of their product if they constantly feed investors’ fears. So of course, that’s what they do. Investors finally get so panicked that they start moving their invested capital from stock mutual funds into money market funds.
Stock portfolio managers are required to cash in stocks in order to meet shareholders’ redemption requests. Here’s the important point: optimally, the portfolio managers don’t own stocks in bad companies, companies lacking earnings growth, companies losing money or companies with overvalued stock prices. The portfolio managers mostly invest in cream-of-the-crop stocks like Adobe Systems and General Motors and Whirlpool.
When shareholders panic and sell, portfolios managers sell their cream-of-the-crop stocks in order to meet the redemption requests. Believe me, they do not want to sell these stocks! They are forced to sell them, based on the panicked behavior of uninformed investors.
That’s why stock prices of good companies fall during market downturns.
On the bright side, that’s also why those stocks’ prices can rapidly rebound. Investment professionals know which stocks are excellent bargains after the market falls. They have their shopping lists ready, as you should! Are you aware that when the market fell last summer, it rose 13.1% from its low to its subsequent high in just 36 days?
You don’t need to be adept at market timing in order to make money in stocks. Focus on these three things:
1. Your investment timeframe. If you seriously expect to own a stock for just a few days or weeks, you’re not an investor, you’re a gambler. Investors should have a several-year timeframe with no immediate need to spend their invested capital on household expenses, tuition payments, etc.
2. Your stock prices are going to bounce around and occasionally make you cringe. Accept it. Stocks present better long-term investment results than “safe” investments because they are more volatile.
Increased risk presents investors with increased reward. Hold your stocks during periods of market volatility so that you can reap the eventual rewards of increasing stock prices.
3. Keep some cash on the sidelines. When market corrections happen, and you have cash to buy low, your entire perspective changes. Instead of panicking at the sight of your falling account balance, you can gleefully look forward to buying shares of your favorite stocks after they’ve fallen 20% or 30%. I love buying low!