Market turmoil - an investor's friend or foe?

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

So smile when you read a headline that says "Investors lose as market falls." Edit it in your mind to "Disinvestors lose as market falls -- but investors gain." Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other. (As they say in golf matches: "Every putt makes someone happy.")

Thanks, Mr Buffett for this eloquent explanation.

Most people don’t like seeing the value of their investments depreciate, which seems sensible enough, but what most people fail to consider is that market declines can be a positive outcome for value investors. By investing the same amount, you automatically buy more assets when prices are low, and fewer when they are high. Meaning that when the market is down your average entry price is lower.

This is especially true when adding to your investment pot over time. Take superannuation savings for example;

Imagine, a young saver in his late 20s who invested 9% of his meagre graduate salary into the Australian equity bull market for the last seven years. The market has been steady, and his monthly updates have made him feel good about investing. If markets were flat for the next, seven years then both his modest current balance and the increasing contributions that he makes would not grow very much. He would feel ok about it as at least it wasn’t falling in value.

Comparatively, say the market fell by 40% tomorrow his initial reaction would be to panic - however, this outcome is likely the better alternative in the long run.

1. Firstly, it is probable that his balance is going to recover in value - that’s how markets work. Investors get scared and then get greedy again. The underlying cash flows coming from the stocks that he owns will most likely continue to grow in line with the Australian economy and over long periods, give or take the odd recession.
2. Secondly, and much more importantly is the magic of compounding and dollar cost averaging, combined with volatile markets. The larger contribution that he makes over the next seven years gets invested at lower prices, meaning he can buy more. These assets then benefit from subsequent rises in the market. You benefit enormously from market volatility just by doing... ...nothing.

These two graphs demonstrate this compounding phenomenon. This investor begins investing in 2005 with a salary of $60K pa and grows at 5% pa (super contributions of 9% pa, quarter). In the first graph after a 40% ‘crash’ the markets grow by 9% pa to end up in the same place after six years. And in the flat/sideways market, without the crash the investor would have to find an investment that delivers 2% more p/a to end up at the same place.

There are, however, a few important caveats, which you could call investment rules that make this strategy work for you:

• Try and do as little as possible. The doing nothing bit can be very difficult. Imagine how differently things could have turned out for the young investor if he panicked just after the 40% fall in markets and moved his money into cash. His existing investments would have almost halved, and both that pot of money, and the new contributions would now only grow at the glacial cash rate. This does not necessarily mean that you should always do nothing but better investment decisions are often the ones that feel wrong. We know that this is difficult, and that’s why we try and help you make those decisions, aided by a bit more information about why something might be cheap or expensive.

• Diversify as much as possible. This comforting view of prices being supported over the long term by relatively stable underlying cash flows is very important and works most of the time in most markets. However, sometimes it doesn’t. Think of Japanese investors who had been flying high up until the end of the eighties. Staying invested just in the local market over the next 20 years would have decimated their savings strategy. Similarly, no amount of patience would have saved the US investor that went all in during the technology boom of the nineties. More generally though diversification (or lack of) is more of a problem for Australian investors than US investors because of the concentrated nature of the local economy and stock market. The current malaise in commodity prices could develop into a longer-term structural slow-down that might adversely affect house prices, the financial services, and banking companies that make up more than 50% of the local stock market. Even if that is just a remote possibility, it makes a lot of sense to spread your money across different economies. You can also over diversify and if you don’t understand where your money is and what makes it rise and fall than you might have reached that point.

• Invest to a time horizon that matches the underlying investments with your objectives. If you are saving for a boat or a house that you want to buy in the next few years, it would be unwise to invest all that money in the share market. It might take ten years to recover from the fall that we talked about before. If you are retiring soon, you might want to think about how much of your money you might need in the short-term and how much you can allow to take advantage of the market dynamics outlined above.

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