All you want to know but never asked about the stocks and options markets.

martes, 16 de diciembre de 2014

Why the stock market always ends up falling and how often?

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An old investor used to say that he knew with 100% accuracy what the stock market was going to do in the short and medium term and with 98% of accuracy the market behaviour in the long term. In the short and medium term, it is certain that the market will fluctuate. That is, it will go up and it will go down, not necessarily in that order. In the long term, the stock market usually rises.

Stock market investors should be prepared for at least a market falling  of 10% a year, a falling of more than 20% every few years, a falling of 30% once or twice in a decade, and a big downtrend of 50% two or three times throughout their life. This means that everyone probably will live 2 or 3 severe economic recessions. That's why the trader should develop an investment strategy which take this into account, because otherwise he or she will learn the lesson the hard way.

But ... why the stock market always ends up falling? It's a question that just a few experts can answer propperly. However, Morgan Housel of the website, responds this question in a very logical manner.
There are many theories of economists who have spent many years studying the behavior of the economy and markets. The economist Hyman Minsky spoke of the danger of market stability, and that stability is destabilizing, much against the investment intuition where you tend to buy when there is no danger in sight and there is calm. In fact, every great crisis comes when volatility indicators were minimal.
Suppose the stock market go up every year by 8% annually. Everyone would know that the stock market always goes up, so nobody would hire bank deposits of 4% or 7%. People would feel secure in purchasing shares forgetting that the stock market is composed of equities (which means more risk than bonds). The stability generates security, and when the people feel more secure they take more risks, such as borrow more or buy shares at exorbitant prices. 
Therefore, if the shares never fell precipitously and generate the perception that they will never going to collapse, the price would rise to the point that would guarantee a terrible crash. Strange but true market paradox. 
We must remember that investing in the stock market really is the purchase of a stake in a company through their shares. We become shareholders of a company hoping that the company distribute its profits with us. We expect the company to continue to grow and therefore we buy shares at a speculative price with the hope that the company will increase their sales and profits to justify the price paid for the shares. Thus, new investors continue to buy shares of the company which increase the price of these equities in the market.
The economy has its ups and downs and economic models are changing, so that in an economic downturn or a change in the economic model, many companies fall while others are born, but that volatility and fear of not knowing what companies will emerge stronger, what companies will never be profitable, and which of them will disappear, causes the market reaches levels of volatility that sometimes topple a stock index up to 50%.

There are never guarantees

Nassim Taleb said that there are never guarantees in investing. There is only a perception of guarantees. In the stock market will always be 14 types of unfortunate events that will be present:
  • Uncertainty
  • Variability
  • Imperfection
  • Incomplete knowledge.
  • Opportunity.
  • Chaos
  • Volatility
  • Disorder
  • Ignorance
  • Randomness
  • Confusion
  • Stress
  • Errors
  • Ignorance

These 14 ingredients almost always end up being in all places and markets and when they occur, the shares which have an overvalued price,
end up falling rapidly. At other times there are falling stocks that are a bargain for new buyers, who make big money with these shares. That's why the errors of some investors are the opportunities to others, and those crises where many lose money offers many opportunities for professional traders who take advantage first of the falling market and second of the new bull market that occurs later. Remember that everyone can make money in a rising or declining market.

The importance of choosing good stocks

One thing is to say that the stock market always goes up, and quite another to say that the shares of a company always rise. Let me explain at this point.
One thing is very clear, is that the S&P 500 will reach 2000 points and probably 2100 points in the medium term. I do not know when it might be in five years or 30, but at some point it will. That does not mean that all stocks listed in this stock index will rise at the same pace. I have no idea. Some companies leave the index while others are included, and that is why markets indices tend to rise, because the companies selected supposedly are the strongest and most promising.

Therefore it is necessary to choose truly solid companies that have gone through several severe economic crisis and which have been strengthened after each crisis. Similarly, hence the importance of diversifying moderately and develop an investment strategy that covers all possible scenarios.

Therefore, we must invest knowing that at some point the stock market will crash, because as Minsky said, the lack of crashes sows the seed of a new accident and markets always crash. Without exception.

So why stock markets fall?

Stock market falls are an absolute necessity to generate high returns in the long term. They are not a mistake and does not always mean that someone has done something wrong. When the profitability of the stock rises, many other assets that fall and vice versa. And that is a balance that must be maintained.

Once you are clear that stocks always crash is when you come to understand certain decisions such as selling a company that has risen 800% to buy another who recently stretched 40%.

Of course as I said before, we are not Warren Buffett to see a storm coming and see our stocks falling 50%. It is sometimes preferable to seeing clouds on the horizon, put our money safe from the storm and come back when there is evidence that the sun will come out.

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