Understanding the Market Sell-off
The pandemic caused by COVID-19 has resulted in market sell-offs across the globe. When markets sell-off, it leaves many of us wondering what’s happening and what to do about it. To help address these questions, I’ll walk through my current thinking of the situation and reference several useful videos and articles that discuss how to approach your investments.
What’s happening in the market?
The stock market functions on forecasts. Investors look at each company and forecast what they expect it to earn over a set period. These forecasts must factor in a range of possible future outcomes since so much is uncertain. A simplified example of this process can be found below.
Valuing a stock
To value an electric car company, you’d want to know how many cars they could sell in the future. To do this, you could forecast how many people in a set population are likely to buy an electric vehicle, and what share of those sales a company would receive.
With only two simplified forecasts, we can see that future outcomes vary significantly. This uncertainty is why stocks have historically provided strong returns to investors. To take on the risk of an unexpected future, investors demand compensation. In the above example, the expected future value of a share of the company is $209.25. While the expected future value is $209.25, an investor may offer to buy the stock today for $150. The difference between what they pay today and expect to receive in the future is the return they earn on their investment.
The amount the investor will pay depends primarily on two things:
The range of future outcomes
A company that has a 50% chance of being worth $1,000 or a 50% chance of being worth $0 has an expected future value of $500. However, there’s a massive difference between having $1,000 or $0, and the prospect of having $0 is very threatening to an investor. Therefore, they may only offer $300 for this investment.
A company that has a 50% chance of being worth $600 or a 50% chance of being worth $400 also has an expected value of $500. In this case, there’s less uncertainty about what the investor will have in the future. Therefore they may offer $450 for this investment.
Their confidence in the numbers
Investors that forecast the future value of a company often have several things they rely on:
Expertise in the industry or area they’re investing
Historical examples to reference for ideas and inputs
Current trends to start with
These tools help provide the investor with confidence that the range of outcomes is realistic, and the likelihoods are reasonable.
The impact of a major unexpected event
When significant, unexpected events occur (e.g., COVID-19, 2008 financial crisis, 9/11, SARS), several things happen to the stock market:
The range of future outcomes changes
Layered on top of each forecast now sits:
The spread and evolution of the virus
Government response (e.g., restrictions, fiscal spending, monetary policy)
Individual reactions (e.g., following guidance, sentiment)
Additional known factors
Potential unknown factors
The outcomes considered can swing quickly, driven by new information and the narratives told.
Confidence in numbers diminishes
At the early stage of a developing situation, there’s very little confidence in current numbers, let alone future forecasts. Recent polls of infectious disease experts vary widely, with very little confidence in specific numbers.
Completing forecasts now requires a multi-disciplinary view. It’s rare, if not impossible, to have a background in epidemiology, economics, psychology, government policy and more. As a result, it’s challenging to have confidence in where we’re headed.
The above causes the stock market to sell-off since there’s now a higher number of potential outcomes and less certainty.
Human behaviour
Added to all of this is human behaviour, and the way we think. In Thinking Fast and Slow, Daniel Kahneman goes through several mental shortcuts that we take and their unintended consequences. I’ll cover a few that seem most relevant to the current situation:
We overweight the likelihood of low probability events. Our mind views a 1% chance as having a more significant weight than it should. Therefore, when there are small chances of substantial losses, our minds will approach the opportunity with greater caution than would be suggested by the math.
We’re better able to remember recent events than historical events. In this case, the salient impact of the virus and rapid sell-off is front and centre for investors. Meanwhile, memories of a growing economy with less uncertainty seems much further away.
What should I do about the market sell-off?
Is the stock market ‘on sale’?
I don’t personally like this phrasing because it diminishes the change that has and will occur. While not as catchy, I like to think of the question as ‘Is the stock market providing an opportunity to take on risk over an extended period to provide the best likelihood of reaching your future goals?’ I believe so.
What we’ve summarized above can help explain why the market has sold-off. It also explains why investors that buy during times of extreme uncertainty have historically earned solid returns as the dust clears and uncertainty falls. However, it also shows that there is the potential that the market continues to decline.
Taking extreme measures like using emergency savings or borrowing money to invest is dangerous. There will be impacts from this virus, that much is certain. The first step from here is to shore up your personal finances, which includes the following:
Having emergency savings or access to low-cost borrowing (e.g., home equity line of credit) to see you through 6 months of mandatory expenses without income.
Paying off any high-interest debt (e.g., credit card).
Once complete, if you have money that you’ve been waiting to invest, or you’re able to lower your spending and save a larger portion of your income for the foreseeable future, you could gradually enter the market over a set period. This approach applies a system to your investing, removing emotions from the equation. It also minimizes the chance of regret and having negative feelings towards the stock market in the future if you were to invest everything, and the market declined further.
What if I’m already invested?
There are two situations to look at here:
You’re invested in a portfolio that is suitable for your goals.
You’re not in an ideal investment for your goals.
Suitable portfolio
Examples that would apply here include:
You have a long window before you need your money
You can adjust your goal as needed (e.g., defer, lower spending)
In this case, it’s important to stick to your initial plan. Having systems in place and following them is the best way to weather these types of events. If you deviate from your plan, emotions begin to take over, and as we’ve seen above, they’re wired against you.
Activities you can take through this sell-off include:
Rebalancing your portfolio to remain at the risk level you’re comfortable with
Understand that the higher risk currently in the market suggests a higher expected return over the long-term
Not an ideal investment
Examples that would apply here include:
You don’t have a diversified portfolio that holds a broad range of companies across countries
You need the money in the near-term
People are often told that the worst time to sell is after a market sell-off. While this is true in most cases, there are times when it can make sense to sell. If you have a short-term goal that you need money for, there’s no guarantee the market will recover in time for you to withdraw. As a result, while it’s not ideal, if you still have enough money to meet your goal, you can sell now and avoid further declines.
In addition, if you don’t have a diverse range of investments, it may be worth selling some of your investments and purchasing a broader set. While the economy has historically recovered from these types of events, and with it the stock market, some industries are never the same. This is one of the primary reasons that holding a diversified portfolio is so important.
Other videos and articles
Ben Felix recently released a great video on the current situation. Ben outlines that these types of sell-offs are expected in the market. He provides logical steps on how to keep your head down and remain invested.
Ben Carlson shared a post on how he’s handling the current market with his money. He covers the importance of personal finances, and what he’ll do if the market continues to decline.
Closing remarks
While these times are going to be challenging for all of us, it’s important to support one another. Please follow the guidance coming from governments and health professionals in your region. If you know others who are nervous about the economy or their investments, please share this post or other resources on the site. We must focus on what we can control. Money is only a tool to help you live a fulfilling life. However, without health and community, it’s of little use.