Here's How the 2020 Stock Market Crash Is Going to Make You a Better Investor
If you have been following the news and the stock markets closely lately, it may seem like the whole world is sinking.
The double whammy of the COVID-19 pandemic and the plunge in oil prices has had a severe impact on global stock prices.
From the start of this year (2 Jan 2020), stock markets have been in free-fall (as of 24 Mar 2020):
- The Straits Times Index (STI) has dropped 27%
- The Hang Seng Index (HSI) has dropped 20%
- The S&P 500 has dropped 25%
We are currently enduring some of the fastest, never before seen market drawdowns ever.
At one point, I was feeling fearful about the situation, and the thought of selling everything to cut my losses crossed my mind
However, I ultimately decided against it.
This led me on the path of reflection as to why I nearly let my emotions dictate my investment decisions.
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.
TL;DR: A Guide to Staying Calm and Making Rational Investing Decisions During a Market Crash
- Understand the nature of the stock market and the power of narratives
- How to overcome the biases that that cause us to make irrational investment decisions
- Understand what the data says about past epidemics
- Do not touch your emergency funds for investments
- Remember the reason for your investment strategy in the first place
The Nature of the Stock Market
It is known that that stock prices blow ‘hot and cold.’
Stock prices are determined by a myriad of factors. But fundamentally, the price of a stock is determined by the demand and supply for it during that point in the market.
This demand and supply is drive by investors who have expectations about the stock’s potential profits and risk.
These expectations tend to change rather regularly causing volatility in prices.
This volatility does not necessarily mean that the market is fundamentally broken or the world is coming to an end.
Steep price declines are an inevitable part of an efficient stock market. Thus, investment plans should always be created with this in mind.
I believe that most of us are able to understand this.
However, there is one issue; every stock market crash feels different. There will always be an overarching narrative or story which is scarier than the actual drop itself.
There is power in a compelling narrative which can cause us to act irrationally.
Take for example the current 2020 stock market crash. If you were to google COVID-19 news, the results will be largely negative as it is the sensational headlines that will draw clicks and come up in your searches.
However, positives still abound.
- It’s back to business in China as signalled by the rise in the WeBank’s China Economic Recovery Index (CERI)
- The COVID situation is improving in China, the epicentre of the COVID-19 outbreak
- Singapore, Canada, Europe and the US are implementing fiscal stimulus measures to actively fix the problems
If we become more aware of this, our minds would not be so clouded with the doom and gloom narrative.
This clarity will help us make better decisions and feel calmer in the current stock market crash situation.
*Do note that we are not downplaying the situation, there’s no saying how long this COVID-19 situation will last. We are just hoping that you would look at the facts of the matter more objectively.
How to Overcome the Biases That Cause us to Make Irrational Investment Decisions
Although the narrative does not change the facts of a situation, it can easily affect how people respond to it.
They can also cause us to have biases that affect our better judgements.
According to Nobel Prize-Winning Economist and Yale professor Rober J. Shiller:
Narratives are human constructs that are mixtures of fact and emotion and human interest and other extraneous detail that form an impression on the human mind.”
In other words, these are the stories we tell ourselves that creates a deep impression on our minds and colours the way we view facts.
The Framing Effect Bias on Investment Decisions
Narratives create a psychological bias called the framing effect.
Generally, the framing effect is the tendency for us to be affected by the way choices are presented to us.
Each individual will react differently to information based on the way it is presented.
The framing effect has a large impact on investment decisions.
An investment option with the same ultimate outcome might be viewed differently by investors.
The option that presents more gains rather than losses will win out.
During the madness of this stock market crash, do be aware of how the information is being presented to you and objectively evaluate your investment decisions.
Representativeness Heuristic on Investment Decisions
Another related psychological bias is the representativeness heuristic.
During uncertain times, people tend to believe that the history of a remarkable performance of a given company is “representative” of general performance that the firm will continue to generate into the future.
People tend to frequently to make the mistake of overestimating the correlation between two similar things or events.
A good example of this would be analysts predicting strong growth for a stock based on historical performance.
A company that has experienced great performance in the last decade might not grow indefinitely into the future.
This bias is ever so relevant during this crash.
Although it may be exciting to buy up a big company’s stocks at rock bottom prices, we urge you to do your homework on the fundamentals of the company instead and not rush in [just because the prices are low].
Understand What the Data Says About Past Epidemics
Narratives will make us believe that this time will be different.
This time might be different but challenging and uncertain times are nothing new in our history.
Humans have survived this.
Just this century we have seen world epidemics such as HIV/AIDS, SARS, Avian Flu (H5N1), MERS, Ebola and more…
According to data from Charles Schwab that tracks the MSCI All Countries World Index (an international equity index, which tracks stocks from 23 developed and 26 emerging markets countries).
Markets have always rebounded so far.
After each epidemic, the index has gone up by an average of 0.4% in the month after an epidemic, 3.1% six months later and 8.5% a year later.
In the past, the world has managed to rebound from past outbreaks and the investors who have taken the risk were rewarded in the long term.
However, in the end, the severity of the virus will dictate the market’s reaction. This time may be different but it is not the time to panic.
Do Not Touch Your Emergency Funds For Investments
In these uncertain times, it is all the more important to set aside an emergency fund and not be tempted to throw it into investments.
As we are more than likely to be headed to a recession, you do not want to be caught unprepared.
The emergency fund will provide you with the peace of mind and clarity to make better decisions and not be forced into cashing out on your investments prematurely.
A good gauge will be about 3-6 months of your expenses. Check out our guide to emergency funds for a quick recap.
Remember the Reason for Your Investment Strategy in the First Place
As uncertainty abounds, it is good to look back on your investment strategy and long term investment goals.
Your portfolio should be something that can weather the good times and bad.
When the market is in decline, it is generally not a good time to get out.
If you were really burnt by the current stock market drop, it may be time to re-evaluate your strategy to see if you are taking too much risk.
Going forward, the path is still unclear.
The economy might get worse and the market might keep dropping. This is what your emergency funds are for.
However, it is important not to let that narrative and fear seep into the investment decision-making process.
In fact, this disruptive 2020 market crash event should be used as an acid test for your risk tolerance and financial strategy.
Take the time to reassess your strategy and make goals for a long term financial plan you can stick to.
If you need help with this, our friendly Seedly Community is on hand to answer your questions about investing.
Please stay safe and healthy everyone and keep washing those hands!