Most of us woke up this morning with a certain amount of uncertainty hanging over our heads. Similar to what we witnessed during the “Brexit” vote just five month earlier, polls, statisticians, and markets didn’t expect the outcome of this election.
As some might have guessed, global markets were sent into an overnight fever of activity as they began forecasting the uncertainties and the impacts on corporate profits and investor returns around the world. Dow Futures lost 700 points in late Tuesday evening while futures trading on the S&P 500 was temporarily halted given its quick 5% descent.
But before you get into the behavioral finance trap, you need to understand that markets rapidly digest and reflect news, information and forecasts, with buyers forecasting that the market will go up and sellers thinking it will go down. Prices of securities move inversely proportional to economic uncertainty, so that the risk appropriate return for the investor is held essentially constant over time (see this article and the diagram below). Because the future is unkown and uncertain, the distribution of actual realized returns is expected to look something like a bell curve, as shown near the bottom of the diagram.
Don’t be fooled by market forecasters who say that everyone is selling or everyone is buying because there is no price change without a buyer AND a seller. At the same moment in time, the fear of the seller is offset by the calm of the buyer. A French mathematician Louis Bachelier, published a now famous paper, The Theory of Speculation, way back on March 29, 1900. He wrote, "the determination of these [price] fluctuations depends on an infinite number of factors; it is, therefore, impossible to aspire to mathematical prediction of it. Contradictory opinions concerning these changes diverge so much that at the same instant buyers believe in a price increase and sellers in a price decrease." Nothing has changed.
I estimate that every day there are about 5 million buyers and 5 million sellers completing about 100 million trades of about 10 billion shares, worth about $450 Billion, in about 45 countries around the world. That is the single best way to aggregate and embed the collective wisdom of millions of minds and bring that wisdom into a spontaneous order that results in a distribution of monthly returns that look very much like a normal distribution over long periods. The average and width of that bell curve represent the risk of the investment as shown in the chart below. Click the various risk levels in the chart below to see the distribution of over 600 monthly returns of several simulated index portfolios.
A lack of understanding about the way markets work can negatively influence our decisions and derail a carefully crafted investment policy and personal financial plan. Don’t let this happen to your plan. Our study of IFA clients determined that those investors who lacked a good understanding of the way markets work earned only about 70% of the return they could have earned.
Taking a big step back from it all is important in developing a well rounded point of view. While temporary changes like 700 points in the Dow may sound like a big deal, it is really just a blip in the grand scheme of the march of capitalism. Our country and our world have made it through very challenging and uncertain times before including economic depressions, world wars, assassinations and revolutions.
A recent article published on MarketWatch highlighted the path of global stocks over the last 500 years by using “composite indexes for Genoa, the Netherlands, and the U.K. for years 1509 to 1788 and then the S&P 500 or its precursors from 1789 onward.” See chart below.
Larger version: ‘A History of Share Prices’
As you can see, while there were times of extreme uncertainty and proportionally extreme market price adjustments, the average return has been positive because there is a positive cost of capital for companies and a proportionally positive expected return for investors, who are the providers of that capital.
Because the efficient market hypothesis tells us that prices are fair and random, the next price is equally likely to go up or down relative to the price that results in a fair return, so we cannot predict the future of stock prices no more than we can predict the future news that determines those prices.
Investors would be well served if they remember that the market is their ally in ensuring that prices constantly reflect our collective wisdom and expectations, which is the best estimate as a society. Investors will always require a positive expected return for the capital they provide and prices will always reflect the uncertainty of that expectation.
Investors are well advised to learn how markets work and realize that all of us know more than any one of us. The very best advice I can give you is to match your investments to your risk capacity and stay the course of rebalancing, following a glide path and loss harvesting in taxable accounts.
We recently developed The Random Walker (a desktop version of this machine) so investors can remind themselves how the markets are working every single day. Stay tuned to find out how you can purchase your own.
About the Author
Mark Hebner - Founder, Index Fund Advisors, Inc.
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.