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What to do when the markets drop?

After a prolonged period of peace and strong growth, stock markets have experienced increased volatility and declines. We bring you recommendations on how to behave during fluctuations in the financial markets in order to finish the journey towards your financial goals on a high note.

Radoslav Kasík | Investment academy | 9. February 2022

Negative articles evoking fear and sensation were, are, and will always be clicked on more often than headlines of articles causing positive emotions. Several investors may have been misled and get nervous due to these articles. People who thought about saving their money more effectively could have been discouraged from the investment and postpone their decision as a result.

However, looking at the headlines from the other side, they could easily be proclaiming "Exceptional Stock Buying Opportunities Continue". So how should we perceive market downturns and what should investors do in such situations?

Purchase opportunity, emergency fund, and regularity of investment

Every good investor views any market decline as an opportunity. Who does not like buying things cheaper? If you are saving for some time to buy a more expensive item or service, a vacation, or a new car and it suddenly appears at a discounted price, you would probably take advantage of it.

The financial markets are no different. Before you start investing, you should build up an emergency fund. The emergency fund of several monthly incomes serves not only the purpose of covering the loss of income, but it will also allow you to make use of opportunities that life offers, including financial and investing ones.

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A simple solution for utilizing market downturns to make good buys is a regular smaller monthly investment. You don't have to waste your time watching the markets, hesitate when to invest, accumulate and move funds, and buy them yourselves

Simply set up a standing order and you will always be guaranteed to buy at good prices when the market falls. Being financially disciplined is very difficult even for someone that is extremely responsible but the regularity of investment can easily ensure it.

Most of our clients are regular investors. In their case, market correction should be a welcome event at the start of saving. The first deposits are appreciated the longest. We have already said that the long-term horizon is an essential condition for a successful investment.

The following chart illustrates the development of a lump sum investment of 10 000 euros for 15 years between May 2003 and May 2018 in comparison to the regular investment of 100 euros per month for the same period in the Finax 100:0 portfolio. It indicates that the fluctuations in the value of savings are reduced due to the regularity of investment.

Note: All data relating to the historical development of the Finax portfolios is modeled and based on data back modeling. We described how to model historical performance in How we model historical portfolio development. Past results are not a guarantee of future returns and your investment may result in a loss. Inform yourself about the risks you are taking when investing.

The fundamental of investing is compound interest

The resulting appreciation of the lump sum investment, despite a short-term decline of more than 50% in 2008, is eventually greater than that of regular investment. The return on a one-off investment is 264% (deposit of 10-thousand euros, final value of €36,446), while the return on a regular investment is only 103% (deposits of 18-thousand euros, final value of €36,496).

The explanation is that this money has been working for a longer time. For the regular investment, you only allow the amount of € 100 (first deposit) to work for the same amount of time. The miracle of compound interest has more room for a lump sum investment.

The graph also confirms the importance of the investment horizon for the investment result. Giving the investment time is more important than trying to predict the market correction.

What is the probability of a greater drop (crash)?

The probability that the decline of markets is just a correction or a smaller bear market is on average about 22 times higher than the probability of a market crash. Therefore, it is impossible to time market crashes.

If you try to anticipate corrections and sell your investment in fear of a downturn, you are more likely to miss out on the growth. On the contrary, it is more likely that the markets will grow without you than that they will fall with you.

We have emphasized this fact back in 2018 and in 2020. The vast majority of clients who have nonetheless pulled out of the market have made a mistake, losing out on returns. They didn't catch the bottom and returned to their investments at higher prices than they sold them due to their fear of potential downturns, or they didn't return at all and have been losing out on the markets' past returns until today.

In other words, by not investing, you have a higher chance of suffering a loss than when investing. The probability of a lost return is many times higher than that of a realized loss. Only invested money earns returns. Cash loses value every year due to inflation, guaranteeing a loss if you decide to hold it.

Missing euphoria

Another interesting rule of the financial markets, that we learned with experience, is that most of the market participants are generally wrong. Large market movements occur when they are not foreseen. Markets are working on expectations, and their failure to do so is a shock.

Today, many market participants expect a decline. They secure their portfolios, reduce exposure, and purchase various protections against drops. There is currently not much room for a shock on the market.

Another significant ingredient of a market crash that is missing is euphoria. Every big sale is preceded by blind trust and limitless optimism, these provide space for negative surprises. However, they are not yet observed in the markets or economies. On the contrary, the investors are more cautious and worried. These are usually the signs of growth.

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Corrections are a natural phenomenon of bull markets just like morning dew in autumn. Short-term downturns show the strength of the market and its health. Continuous growth is dangerous because it comes hand in hand with euphoria and the risk of unpleasant surprises.

What should you do when a drop occurs?

In Finax, we prefer passive investing and seek to avoid market forecasting. Our experience has led us to this approach. Trying to anticipate, time, and actively manage investments does not usually lead to better results and is unnecessarily expensive.

The following factors are important for the outcome of the investment:

What we recommend to do when markets drop in order to be satisfied and earn as much as possible:

  • Nothing,
  • If you have not started investing yet, start as soon as possible
  • Gradually invest more,
  • Abide by the investment horizon,
  • Do not follow your investment extensively,
  • Rather use your free time at work, with family or for your hobbies,
  • Or think where could you spare some money that could be invested,
  • Stay calm because you know that your savings are well protected.

In the end, only savings and large enough assets will protect you from the next crisis. So, if you want to be ready for the next crisis, start saving as soon as possible, build an emergency fund and invest. It is easier to handle the next financial crisis with assets in the accounts rather than with a zero in the account.

The tax regime depends on each client's individual circumstances and may change in the future.

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