When Disaster Strikes

Oh no! When Disaster Strikes

Thanks to Covid I can confidently say that anyone who is old enough to be reading this blog has now lived through a market downturn. (I had to be a bit flexible prior to that.) Sometimes there are events which are so significant that they affect the whole market, and the general sense of everything falling apart can be overwhelming.

We looked at risk last week, which mostly covered how to avoid those bad times as best we can, but what can we do when we're actually living through them?

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Time heals wounds

One of the reasons that higher risk investments are recommended for those with a longer time window is that eventually the market comes around. It's rarely overnight, and the bigger the downturn then often the time to recover is longer, but recoveries are the norm. If we have time to wait it out then chances are we'll see our investments return to, or exceed, their former value.

This means that one of the best strategies we have in a time of market volatility is to do nothing. Except perhaps to stop looking at the finance news until it's less anxiety-inducing. To understand why, we need to consider that very often the only determinant of share price is the price at which someone is prepared to buy or sell it.

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What are we actually buying?

If we buy 100 shares of “Widgets R Us” (WRU) and they each cost $10, then the value of our investment is $1,000. In a year, WRU does very well and the shares are now selling at $15 each. The value of our portfolio is calculated at $1,500. We haven't actually bought any new shares, and we still only own 100 of them, but they would be worth more if converted to cash.

Then a year later, the market crashes, and our shares lose 50% of their value and are selling at $7.50 each. The portfolio is looking sad at $750, and we still own 100 shares. Five years later, things are looking much better and WRU is trading at $20 – our portfolio is worth $2,000. We still have 100 shares.

The thing that didn't change during this time was the number of shares held. While the price that other people were willing to pay for those shares fluctuated dramatically, the underlying asset was the same. The dividends might have fluctuated too as the company experienced good and bad times, but even if the sale value of my portfolio is cut in half, I still have 100 shares.

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We don't have to sell

Unless we're being forced to close our portfolio for some reason, such as needing the money for an emergency, we don't have to sell the shares until we are ready. Even when our shares drop to $7.50 each, there is nothing inherent in the investment which forces us to accept the price offered and cash out, much like when someone makes us a ridiculously low offer for the car we're selling. If we have the choice not to sell, we're in a much better position to remind ourselves that we still have 100 shares and things might get better.

The value of the portfolio is the cash price if we choose to exit that day. If we have an emergency fund set aside, and we're not about to retire, then we can wait for a better offer to come along.

You might have heard the term 'crystalising losses' – this is when someone chooses to exit from the investment at a time when it has lower value. Until they exit, the loss is only theoretical, but selling up makes it real.

If Widgets R Us cannot make it through a market crash and becomes insolvent, then our loss is very real and out of our hands. This is the specific risk facing a particular company which we talked about last time, combined with the market risk of a crash. Not all companies survive and the quality of our underlying asset is important too. But creating a loss by selling low when we don't need to is a disaster we can avoid.

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Patience and perspective

Investing is always going to carry risk, but we can apply patience and perspective when the almost-inevitable happens and we get hit by a disaster we can't avoid. We can keep in mind that it is only the sale value of our asset which has changed, and we don't have to sell at that price. We can wait patiently until things turn the corner, and see our portfolio value rise again.

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* The information provided in this article is general information only and does not take into account your objectives, financial situation or needs. Before making a financial decision, please assess the appropriateness of the information to your individual circumstances and consider seeking professional advice.

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