The Standard & Poors 500 index (SP500) has risen steadily for the past five years, until it took several sharp drops starting in early October. The SP500, which tracks overall stock market activity, is an index made up of 500 of the largest companies representing the wide spectrum of American commerce. According to Bill Schwert, Distinguished University Professor and professor of finance and statistics at the Simon Business School, the SP500 tells us something about people’s confidence in the economy. But he advises investors to “take a long view.”
All calculations below were valid as of October 25, 2018.
How concerned should the investing public be about the recent downturn?
One thing I can say with certainty is that stock prices do not always go up (or down). My best advice to investors is to take a long view when investing in stocks. You should not think about selling in reaction to recent decreases (or increases) in stock prices. The evidence is fairly strong that it is very hard to time future movements in stock prices. Following a passive buy-and-hold strategy will save transaction costs and capital gains liabilities in most cases. After all, the Standard & Poor’s 500 portfolio has increased 56 percent in the last five years, and that does not include the dividends received by stockholders over that period.
Market analysts routinely give reasons for market fluctuations. How accurate are those analyses?
Most daily commentators describe theories for why stock prices moved that are either tautological (“buyers out-numbered the sellers”) or inconsistent from day to day (for example, attributing price moves to good or bad employment news). The market is much too complicated to be diagnosed on a daily basis by these kinds of simple descriptions. On the other hand, there is a large demand for simple stories and the news media usually seek to deliver stories that meet that demand.
If investors shouldn’t react to periodic downturns, what should guide their decision making instead?
I think the most important concept that investors should focus on is the benefit of diversification. Most people are interested in identifying a small number of stocks that will be winners in future periods. It is very hard for anyone to accomplish this—and it is impossible for all investors to do this at the same time. Nevertheless, most people enjoy reading and learning about individual firms, or even industries, to try to identify stocks that will be great investments for the future.
Instead, following a buy-and-hold strategy (buying or selling very infrequently) in a low-cost, well-diversified mutual fund or exchange-traded fund will deliver better long-term performance. The risk will be much smaller and there will be no loss of expected returns. The only downside is that you will not find interesting stories to read about related to your investment portfolio.
How much influence does the Federal Reserve—or the president—have on the stock market?
The Fed and the federal government certainly create the environment in which firms operate. Tight credit markets raise the cost of borrowing to finance business expansion. Tax and regulatory policy certainly affect the profitability of business plans. Perhaps most importantly, uncertainty about future government policies can stifle firms’ willingness to make large investments. My best guess about the reason that stock prices have risen in the last couple of years is that firms and investors are optimistic about future tax and regulatory policies and their effect on future risk and profitability.