What to do when the markets drop?

The spread of coronavirus from China to the rest of the world has alarmed many investors. After a longer period of calm, the stock markets recorded markedly declines. Here's how to behave during the financial market crisis.

Radoslav Kasík | Investment academy | 27. February 2020

Last week, the media headlines were once again flooded with sensationalism and click baiting headlines about market drops asking the question whether the next financial crisis is coming or not. Several investors may have been misled and got nervous from these articles. People, that thought about saving their money more effectively could have been discouraged from the investment and as a result postpone their decision.

Every person is mistakenly trying to time their investment. Beginner investors are trying to find the bottom and the top of the markets, thinking, that this is the best way to maximize their return. This idea is nice, might seem also logical and it would be awesome if you could manage your financial assets this way, but in practice it is a “tilting at windmills”. Proper timing of investment is impossible and the result of these efforts tends to be the opposite.

"Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves." Peter Lynch.

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Peter Lynch is a legendary manager who managed the most successful Magellan mutual fund at Fidelity Investments. Lynch was really one in a million. During his management, the fund earned on average 29% per year, more than twice the performance of the S&P 500.

Peter Lynch knows what he's talking about. His statement can be complemented by a number of similar quotes from other experienced economists and legendary Wall Street investors.

No one can predict the development of markets

A precondition for a successful investment is to keep this rule in mind. Otherwise, you will always be dissatisfied with your investments and they will disturb you during night. Ultimately, you won't earn the potential returns that markets offer you.

Not abiding by this rule is a common mistake of investors. Excessive self-confidence, herd mentality and fear of loss are emotions that will overwhelm the investor in such situations. These are the so-called limitations of mind, which are the biggest enemy of successful investments.

These limitations are described by numerous studies in the field of behavioral economics and finance. In recent years these field have grown in popularity and the researches in these topics have won several Nobel awards for economics. Behavioral finance does not look at economics as an exact, logical or rational science, but as a science influenced by human decision-making based on psychological stimulus.

Passive Investing

In the US, several economists have conducted studies that looked at the relationship between investor behavior and performance of the investment. All of them confirmed that more active investors achieve in the long-term lower returns than the market returns. The cause of these lower returns is poor decision timing and higher investment costs.

This is also true for investors who visit their investment account more often to regularly check the investment balance. Every visit creates an incentive to invest.

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This difference of returns between the market and the active investor was described by the well-known financial author and illustrator Carl Richards as the so-called behavior gap, a term that has subsequently become established in finance and can be loosely translated as a loss caused by the behavior of investor. These studies quantified the loss of investors as a result of frequent and unnecessary market decisions ranging from -1.17% to -4.3%.

In Finax, we used these studies as a foundation when we were creating Intelligent Investing and therefore, decided to come up with passive investing. It is the reduction of human decisions that leads to a lower risk and costs, which in addition to the long-term horizon, are key factors for the success of the investment.

These studies also clearly confirm that the pursuit of market timing has led to worse results in the long term and is therefore unnecessary.

Investment horizon, right allocation and the algorithm of robo-advisor

Market time is important for investment, not market timing.”

Every intelligent investor in Finax will, at the beginning of his/her registration, be asked about the investment and about his/her risk profile. Based on the answers, the unique robo-advisor algorithm selects the appropriate portfolio for the investor, precisely matched to the investor's risk profile.

If you are a cautious person who is afraid of a decline of investment, we would choose a more conservative strategy with a larger share of bonds. The fluctuations of such a portfolio are considerably lower than those with a larger share of equities.

The investment horizon (investment duration) is one of the most important factors when selecting a particular portfolio. The algorithm is programmed to select a strategy that is most likely to perform well on your specified horizon, according to the historical Intelligent Investing portfolio statistics.

Market risk - the only risk of investment in Finax that has always been taken care of by time

We can say that the only risk you take when investing with Finax is market risk. Market risk is the decline in value of the investment due to the movement of the indices. However, market risk reduces with time, as stated in the table below. When we increase the investment horizon the market risk gradually decreases to zero, as you can read in this article.

With Intelligent Investing you do not take any other risks. Your investment is divided between more than 10,000 securities across all sectors, continents and different issuers. We invest through strictly regulated ETF index funds of renowned managers.

Abiding by the horizon is a must for a successful and profitable investment. If you answered the questions during the registration correctly, your investment has nothing to worry about.

The average investment horizon of active accounts in Finax that our clients set when opening their accounts is 17 years. From this point of view, the current market fluctuations are absolutely negligible and with this horizon our clients have absolutely nothing to worry about.

Purchase opportunity, emergency fund and regularity of investment

Every good investor looks at any drop of markets 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. Even before you start investing, or at the same time, 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 us of opportunities that life offers, including financial and investing ones.

It is financially correct decision to gradually dissolve part of the emergency fund in order to create long-term asset, when markets offer bargain prices. After that build up your emergency fund once again, so that you can be ready for unforeseen life events or another market opportunity.

A simple solution for taking advantage of market downturns in order to get the best purchase prices is investing regularly and in smaller parts. You don't have to waste your time with tracking markets, thinking when to invest or with accumulating, transferring and buying assets.

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Simply set up a standing order and you will always be guaranteed to buy at good prices when market falls. Financial discipline is very difficult even for someone that is extremely responsible but the regularity of investment that 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.

If markets drop at the beginning of saving, investors are guaranteed that their first purchases, which are most important for the future outcome, will be cheap and therefore advantageous.

The following chart illustrates the development of a lump sum investment of EUR 10 000, 15 years ago in comparison to the regular investment of EUR 100 per month for the same period of time in the Finax 100:0 portfolio. It indicates that the fluctuations of savings are reduced due to the regularity of investment.

Note: All data relating to the historical development of the Finax portfolios is modelled and based on data back modelling. We described how to model historical performance in How do we model historical portfolio development. Past results are not a guarantee of future returns and your investment may result in a loss.

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 a regular investment (€ 10,000 deposit, € 36,446 final or € 18,000 deposit and € 36,496 final value in case of regular investment).

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)?

As we have already indicated, no one knows the answer to this question. The media and the analysts calling for a new financial crisis refer to the continuous market growth, several problems in the economy and world politics, and the ending of incentives from central banks.

But the statistics do not support their argument. In the modern history of markets dating back almost a hundred years, we have witnessed only five drops in stock markets of more than 40% (crash). During any 30-year period, the crash occurred most of the time only once, and in less than a third of the periods twice.

If there were another crash in the upcoming years, it would be the third one in 20 years. The first one was the burst of the Internet bubble in 2000 and the second one was the financial crisis in 2008. The repetition of two major crashes in such a short time horizon was very unusual. History therefore, does not give a high chance that the next crisis is happening soon.

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The market correction is considered to be a decline of more than 10%. Between 1983 and 2011, market correction occurred in more than half of all quarters. On average, this means that markets recorded 2.27 corrections per year.

Decline of more than 20% is called a bear market. This appeared in less than a fifth of all quarters, i.e. 0.72 times a year.

Since 1950, the US stock index S&P 500 has experienced 36 corrections greater than 10%. 21 of these lasted less than half a year.

What do we want to say with these statistics?

The probability that the decline of markets is just a correction or a smaller bear market is on average about 30 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 as that they will fall with you.

In other words, by not investing, you have a higher chance of suffering a loss than when investing. The probability of lost return is many times higher than the realized loss.

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 more significant decline. They secure their portfolios, reduce exposure and purchase various protection against drops. There is currently not much room for a shock on the market.

And the significant ingredient of 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 cautions and worried. These are usually the signs of growth.

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 the euphoria and the risk of unpleasant surprises.

Let your money make money 

Try invest tax smart with low cost ETF funds.

What should you do when drop occurs?

In Finax, we prefer passive investing and we 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:

  • Right allocation - the correct portfolio composition is made with the help of our algorithm, and it makes your investment fit your goals and risk profile,
  • Long enough investment horizon - the portfolio selection is adapted to it,
  • Low fees,
  • Sufficient diversification - risk distribution,
  • Optimizing tax,
  • Regularity,
  •  Rebalancing - we offer a unique way of automated rebalancing as another risk management tool that keeps the portfolio risk at an appropriate level. In the event of market turbulence, it automatically sells the expensive assets and buys cheaper assets

What we recommend to do when markets drop so you can be happy and earn as much as possible:

  1. Nothing,
  2. If you have not started investing yet, start as soon as possible
  3. Gradually invest more,
  4. Abide by the investment horizon,
  5. Do not follow your investment extensively,
  6. Rather use your free time in work, with family or for your hobbies,
  7. Or think where could you spare some money that could be invested,
  8. 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 next financial crisis with assets in the accounts rather than with a zero in the account.

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