I met with a client recently who asked me “Why is it that when the stock market goes down, some investors also decide to sell their stock?” This is a completely sensible question because if nothing notable changed in the stock of the business, even if the market drops, why would it be expected to suddenly receive a lower value? The answer comes down to understanding the difference between traders and investors, and understanding that each market participant has a different reason for the action that they’re taking.
How traders view the market
Generally, traders buy stocks because they think they’re going to go up. They don’t necessarily care about the company’s management, or their 10-year growth prospects, or what new products they’ll be launching five years from now. Their focus is what’s going on right now. What might impact the price of the stock in the short term? Even among traders, each one of them has a nuanced opinion about the stock they own, and each of them will likely interpret news, events, and supply and demand imbalances differently.
How investors approach stocks
While traders generally focus on the short term, investors typically focus more on the long term. They are more interested in the potential growth of the business over the next several years rather than the price movement on any particular day. Investors care about the long-term profitability of the company they’re buying. They believe that the fundamentals of the business will eventually be reflected in the price of the stock when they sell their shares at some point in the future.
What’s particularly confusing for many clients is understanding that traders and investors are operating alongside one another. They both have totally different reasons for selecting their investments, but they trade their stocks on the same markets.
The difference between trading and investing
Both methods may offer the chance at profit, but I would argue that many people don’t succeed as traders. The reason is that they’re competing with people (or computers designed by people) with more access to information and technology. In Michael Lewis’s book “Flash Boys,” he tells the story of a company that built a tunnel through Pennsylvania’s Allegheny Mountains to run fiber optic cable from the New York stock exchanges to the Chicago futures exchanges in an effort to shave three thousandths of a second in data transmission time. If you think you can compete with that, good luck.
On the other hand, an investor who bought a diversified portfolio of the great American businesses and proceeded to sit on their hands for the past thirty years would likely be pleased with the returns over that period. Now that might not seem very exciting. And doing nothing certainly required some significant bravery, think 1987, 1998, 2000, 2001, 2008, and 2009, or during any of the other normal 10% short-term declines we have had every year or so. But had they remained invested in the S&P 500 from June 30, 1986 to June 30, 2016, they would have received a roughly 1,555.841 % cumulative rate of return or an annualized return of 9.808 % including reinvested dividends. *
To go back to my client’s original question “why is it that when the stock market goes down, some investors decide to also sell their stock?”. The best answer is probably “not for any good reason”. Once you change your view of market declines from catastrophe to opportunity, you might sleep better at night and your investment portfolio just might perform better too.
* https://dqydj.com/sp-500-return-calculator/ beginning date of June 1986 and end date of June 2016.