“Stock market corrections are very common and thus are inevitable part of investing. Since 1932, declines of 10% to 20% have occurred an average of every two years, according to InvesTech Research. Year 2016 started with plunging stock prices all over the globe, causing panic among investors. However, a drop of similar magnitude happened 4 years ago in 2011-2012. The character of the equity market is constant: what goes up can’t go up forever,” points out Nordea Savings experts in Baltic countries.
The decision to enter financial markets with your first investment is never an easy one. It requires finding suitable instruments to invest into and choosing the right time to enter.
At the same time, corrections in the stock market are normal and investors shouldn`t be afraid of them.
At the same time, history has shown that even if equity market faces a meaningful price decline within calendar year, it does not mean that the year finish with negative return. World equities face intrayear declines in more than 60% of years, with the average lowest point being -6%. However 71% of years ended with a positive return,” says Nordea Savings Latvia team leader Anželika Dobrovoļska.
* World equity index annual returns (blue). Lowest intrayear return (red), based on monthly data.
Even short-term market declines take place regularly; this shouldn’t worry long-term investors too much. History also shows that in the long run equity markets always overcome recessions.
* Blue line shows World Equity Index performance.
How can investors limit their risks and benefit from an unstable market?
Various investment solutions developed by financial institutions significantly simplify optimal portfolio construction, while MiFID regulation ensures that the strategy offered to the client matches his goals and risk tolerance.
However, the most frequently asked question is when is the right time to invest? If prices have been going up, then everything seems expensive and investors are reluctant to buy. Yet when prices are dropping, people are similarly disinclined to buy, expecting even more downside. As a result, it never seems to be the right time to buy.
The most obvious recommendation would be to buy as cheap as possible. Yet, many studies have shown that nearly everyone who tries to time the market loses money. The generally successful strategy is buying undervalued while selling overvalued assets.
Although this strategy is fairly simple, it requires strict discipline to buy after big market declines. Price drops usually cause panic among investors, who try to exit their positions at any price, giving prudent buyers the opportunity to get a good price.
To evaluate how this simple strategy works in the real world, we tested the following trading rules on historical data from the world equity index (December 1969 to January 2016, monthly data):
There were 7 cases during the analyzed period when our buy rule was triggered. The average 5-year total return for this strategy was 62.0%, compared to 47.4%, which is the average 5-year total return of the index during the analyzed period. Moreover, in 5 out of 7 cases the investment started earning profit as early as the first year.
Another powerful way to turn price fluctuations to your advantage is regular investing. To illustrate that, let’s analyze the following example.
An investor is offered two options:
Which option would you choose? Though the second option seems to be the best, it actually may cost you a good return. The reason is that when the price drops, an investor gets more shares (stocks, fund shares) for the same sum, which will result in a better return when the price recovers.
Let`s take a real situation as an example. What happens when the investor decides to start making regular investments of 1 000 EUR per month, starting at the worst possible time, October 2007, the highest point before the crash? The calculations show that a regular investor would be in a much better situation today in comparison with a one-time investor.
World Equity Index, lumpsum investment
The graph shows historical prices of world equity index and the total return of the potential lumpsum investment, done on 31.10.2007. Source: www.msci.com
World Equity Index, regular monthly investment
The graph shows the performance of regular investment strategy, starting on 31.10.2007 and investing equal amount at the end of each month. The value shown is portfolio value minus the amount invested i.e. absolute return. Source: www.msci.com
As we have clearly shown, volatility and price declines are not reasons for worry as they provide great earning opportunities for prudent investors. However, it is vital to remember that staying within one’s risk tolerance limits is especially important during turbulent times.
Moreover, studies show that having a clear written financial plan makes it easier for investors to tolerate market declines. So, the main advice for private investors is to build an optimal portfolio and survive during market turmoil,” says Savings Latvia team leader Anželika Dobrovoļska.
DISCLAIMER
Historical returns shown in the article are solely for informational purposes. Historical returns cannot be regarded as a safe indicator of the future investment results –actual returns may differ significantly from the ones specified in this article. The value of the investment portfolio may grow or shrink depending on the developments in the global financial markets, which are affected by a number of risk factors. Investor may lose part or all of his invested capital. Nordea bears no responsibility for any losses that the customer might incur by relying on the information contained in this article. Shown historical performance of backtested strategies does not include any transaction costs, taxes or any other fees that may apply. Such historical performance is presented for information purpose only. Investors’ actual investment result may differ from the one presented here.