I believe it is always important to keep in mind that the stock market as with other markets is essentially an auction. For example, if there is a farm auction or estate sale and no one bids, the price goes down until someone bids. If the auctioneer wants to sell a used tractor for the estimated market value price of $10,000 and no one bids, the auctioneer will reduce the bidding price until someone at the auction bids. If the first bid does not take place until the auctioneer has lowered the price to $1,000, that is what sale price will be. On the other hand, if there is multiple bids for the tractor because of future perceived value, the sale price will exceed $10,000 until there are no more bids. Finally, the owner of the tractor may instruct the auctioneer that the tractor does not sell for $10,000, in other words the bids are less than $10,000, to take the tractor out of the auction in hopes for selling it at a later date when there is more demand.
Many investors assume, wrongly in my opinion, that when there is a decline in market value, they are losing money. I continue to say the only time an investor does make or lose money on an investment is when the investment is actually sold.
Rapid stock market declines are not unusual. They can happen for many reasons and multiple factors can be involved.
For example, the market crash in October, 1987, was in my estimation, primarily caused program trading which I would consider to be the beginning of the computer-generated trades. Investment firms told their clients, most often wealthy clients, they would not lose money in a stock market decline, because the advisory firm would sell them immediately at the beginning of the decline. Turns out the elite of investment firms at that time had not figured out that if a large number of advisor firms put in a sell order for all of their clients at the same time, it is like the above auction, no buyers and a lot of sellers. When this happens, markets can decline very quickly.
A related and significant factor in 1987 and other market declines are margin calls. A margin account is when investors are confident a specific investment will increase in market value and use the equity in their account to borrow from the brokerage account to buy more of the investment. The amount which an investor an investor can margin is regulated by securities law. A margin call takes place when the investment drops in market value below the brokerage firms “maintenance” margin requirements. At that time, the investor must add cash to the account paying down on the loan, add more equity, or shares of an investment or sold until the maintenance ratio is met. In a rapid decline investors often receive margin calls and if they do not have cash or equity to add to the account, shares of the investment are sold which adds to the number of sellers in the market driving prices even farther and faster.
Now fast forward to today’s market place which is driven by large institutional investors and hedge funds with computers using algorithms making trades in Nano-seconds. Some are momentum investors, some short sellers, and some are using very sophisticated options and futures striving to make profits and avoid losses. In these situations, do not think in terms of years, months, days or hours, think in terms of Nano-seconds.
The rapid decline beginning the end of this January had nothing to do with long term valuations in my estimation. Rather it was due to some very large number of institutional investors using very sophisticated options and futures contracts which went against the investors driving the market down very quickly.
Be it in 1987 or a few days ago, the “average” investor sees the news and our current 24-hour news cycle is not a good think, does not have the educational or experience level to understand what is taking place, believes they are losing money, panics, sells their holding and do lose money. It is the equivalent of jumping over a cliff to avoid jumping over a cliff.
What should the average investor do. Read my article on “Are you and average investor.”
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.