|I jumped in the water after I took this picture.|
I may talk more about this in the future, but my master's thesis research involves looking at what people did with their investments during the recent Great Recession. Over 30% of (representative of the US) individuals changed their asset allocation in retirement accounts, most away from stocks and into 'safer' investments like bonds. I care a great deal (as a researcher, but also as a person) about the decisions people make in times of crisis, because otherwise the pull of inertia is strong (doing nothing is easier than doing something), so investment decisions and changes have impacts that carry on for years to come. Also, because people are often reacting emotionally in these situations, they tend to make crappy, wealth-destroying decisions.
I mentioned earlier than I tabulated the losses we experienced in the market, then moved on with life. There was a lot of work and effort and learning involved in getting to a place where I could take a moment to feel sad, then look to see if we're able to increase our planned investments to take advantage of lower prices, then move on and feel happy and not consumed by the loss. First, there was the very long self-education on investing - mostly from reading personal finance and investing books, working with a financial advisor, and forums like the Bogleheads. When I first started learning, the jargon was confusing and I didn't understand and absorb everything on every page. But continually reading new books reinforced what I knew, and built up my basic knowledge. Now, when I pick up a mainstream book about finances, I expect less than 5 percent to be new information, and the rest reinforcement.
So, the stock market. Buying a stock in a company means you're becoming one of the owners, and thus getting ownership of a tiny sliver of the future profits. When you buy funds as opposed to individual stocks, you buy many companies at once. An index fund or ETF fund allows you to buy, at usually a low cost, stocks of many many companies and so have a broad swath of investments. In theory, the price at any given time of any given company's stock is equal to what investors in the market believe they will get paid in the future for owning a bit of the company. So, companies that are expected to have high profits will be more expensive than companies that are expected to have lower profits. But, there are lots of diverse players in the market with different information, and all sorts of complications to this nice theory.
There's a quote I love, about the stock market being a weighing machine in the long run, but a slot machine in the short run. Essentially, a business with a sound strategy and valuable product that makes lots of money, will go up in price in the stock market, because people will place a high value on owning a piece of that company. The opposite can be said for a company that's not delivering a great product or executing its vision well - the stock price will go down, because people won't be willing to pay much to own a piece of the company. However, in the short run? Who the hell knows what will happen, or what a stock price will be. This might be as random (and unpredictable) as a slot machine. All this is to say that in the long run, stock prices are supposed to be indicative of the value of the company, which is based on its fundamentals, but that in the short run - be careful about reading too much into the price of a company's stock.
The recent decline is just a blip on my radar, because I invest for the long term, and I don't much care about what my investments are worth in the short run (the next month or even the next year). But wait, why invest in stocks in the first place, if events like the recent decline happen? The answer to that is that inflation (historically ~3% per year in the US) eats away at the value of your money, and that if you hope to have lots of money to make use of in the future, you need to invest (in part) in stocks. Stocks are historically the best way to beat inflation. An investment that is 'safer' and has less movement in price (volatility) but lower returns can do you a lot of harm in the long run if you're not beating inflation, because the value of your money is eroding.
On the other hand, investing in stocks does come at a price. While the stock market generally tends to increase in value ( a lot), it's not a smooth ride. Declines can be very quick and lumpy, and predicting them consistently is impossible, or at least - nobody's done it yet. So if you invest heavily in stocks, there will be losses of 30, 40, or 50 percent at times. Yes, timeS, plural. There's nothing you can do about that, but you CAN avoid making poor, rash, decisions (that will leave you poor). Think before selling your stocks at a time when they are priced lower and effectively 'on sale', and the price may be temporarily out of whack with the actual $ value you receive from owning a sliver of the company. You will get little money for selling your stocks, and miss out on the eventual recovery that (historically) has always happened, eventually, in spurts that are just as hard to predict or time as the losses.
So what should one do when the stock market (as a whole) falls? Nothing, just be cool. It's not easy, but you can set up systems for yourself to prevent emotional over-reactions. I, for one, no longer check my investments constantly like I used to. It was so easy - they were aggregated on Mint, and updated whenever I logged in. But, while I felt slightly happy when the investments were up, I felt way more horrid when they were down. Now, I only check at the end of each month and so avoid the internal panic that fluctuations stir up in me (before my rational half can tamp them down).
How did you feel with the recent market declines? How did you handle them?