The recent turmoil in world stock markets has relevance to only one person – you. Its relevance depends on the amount of money you have invested in stock markets. Most people who work have some exposure to shares through their superannuation or pension funds.
We humans are loss averse. We are more concerned about losing money than we are about making it. In their book Nudge, Richard Thaler and Cass Sunstein explain how we hate losses twice as much as we like gains. In numbers, that means we’re more concerned about losing $5,000 than making $10,000. This explains, in part, the market panic that has set in.
It’s important to know that if you own a $500,000 house and its value falls 10%, you don’t actually lose $50,000 – except if you sell your house. Similarly, if your house price rises by 10%, you don’t make $50,000. The same applies to stock markets. Losses or gains only become real when we sell.
Here are some points to keep in mind:
- It’s not the number of points a stock market falls, it’s the percentage it falls that matters. The higher a market index is, the more a fall in point numbers seems significant. So, if the Dow Jones sheds 1,000 points from a level of 20,000, it has fallen by 5%. But most news outlets report the fall in points because it sounds worse than the percentage – and bad news sells. To get back to its previous level, the Dow Jones only needs to increase by 5.26%. Similarly, if it falls by 10%, then it needs to rise by 11.11% to get back to its original 20,000 points. My advice is to be like Rip Van Winkle, who fell asleep for 20 years and missed the American Revolution. Pretend the market isn’t there – what you don’t know you don’t have to worry about.
- If you invest on a regular basis, as most people do through superannuation contributions, then you benefit from what’s known as “dollar cost averaging”. This is where your funds are invested every month or every quarter, ignoring the rise and fall of markets.
- Remember the words of Warren Buffett, the world’s most successful investor: ” In the short run, the stock market is a voting machine, but in the long run it’s a weighing machine.” Your shares are not invested in a market per se, they are invested in individual businesses that make up that market.
The best way to navigate the current situation, or any future challenging situation with markets, is to:
- Get specific advice for your situation. If you do not know a financial planner, get a referral for one.
- Become better informed. For example, subscribe to the Cuffelinks newsletter, which provides a wealth of information on markets and investing.
- Understand YOUR psychology about money and markets. Remember, it is usually better to plan for things before they happen rather than react after the fact.
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