HOW UNDERSTANDING MARKET CYCLES MAKES YOU A BETTER INVESTOR
As with life, the market goes through cycles, both of which are beyond our control. What we can control is our response. Investors typically react opposite of their best interests-wanting to buy when markets are high and sell when markets are low. Advisors at the Global Asset Management Company in Seoul recommend three steps for overcoming our emotions vis-à-vis investment decision-making:
- Learn the basics about market cycles to avoid reacting emotionally as they change
- Prioritize your goals within your own life cycle and decide how much risk you can honestly afford to take financially
- Establish a long-term investment plan that lays out your goals, your situation and risk tolerance. Stick to it no matter what is happening in the market
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MANAGING EMOTIONS THROUGHOUT MARKET CYCLES
Economic cycles can range from two years to over a decade. Stock market cycles lead economic cycles by 6-12 months. Investors who succeed through-out repeated cycles learn to recognize the difference between what they instinctively want to do, and what they should do.
GAM (Global Asset Management) advisors report this is one of the most difficult aspects of their work. When stock prices are high, greed tempts people to buy. When markets are in a downturn and prices are low, fear leads people to want to sell. This flies in the face of common sense. Even a child is familiar with the mantra: buy low and sell high.
The best way to control one’s impulses and make objective decisions is by having a written investment plan and sticking to it. The first step in objectivity is learning about market cycles and appropriate reactions.
Markets peak after a period of strong economic growth and low interest rates. At the top, the economy is still growing but the rate of growth is slowing. Usually interest rates are falling to stimulate growth, and unemployment remains low. During this interval, corporate earnings show signs of pressure and the risk of recession rises.
The problem is that stock market gains are a buzz and in this state of elation, people want to buy even as market risk increases. This is a great time to re-balance a portfolio. Asset classes that have risen above their intended allocations should be trimmed back like hedges to their ideal shape. In doing so, the investor locks in profits and raises cash.
Once the market peaks, it starts to come down. Indicators that the economy is in or nearing recession include rising unemployment, falling corporate profits and downward stock market trends. The Fed will have begun rate cuts. This is the start of the bear market. At first, people will be optimistic that a correction is at hand and the bull market will continue.
Eventually reality sets in along with negative emotions leading to a temptation to sell. This stage of the market cycle requires patience. Investors should review their investment plan and ensure that all holdings contribute to achieving long- and mid-term goals. Do not panic and go to cash.
Think of this period as the dark before dawn. Just like the market top, it won’t last forever. Economists define a recession as two consecutive quarters of negative economic growth, based on a country’s GDP (gross domestic product). During this time, expect falling inflation, rising unemployment, and declining corporate profits. Stock prices trend down.
Eventually, there will be a catalyst to turn things around, which is often the Federal Reserve cutting interest rates to inject liquidity into the economy, stimulating spending and leading to growth once again. This can be a depressing time for emotional investors.
But it’s the best time in the market for wise investors who trimmed their hedges at the top of the market. They have cash on hand to buy stocks at a deep discount, providing the best opportunity for long-term growth and wealth creation. This is the time to buy, not cry.
The market equivalent of a crocus peeking through the snow, this is the start of a new bull market. Economic indicators include employment upticks, low interest rates and sudden upturns in corporate profits.
To underscore the importance to investors of being fully invested at this point in the cycle, note: the year after a market bottom the S&P increases by an average of 47%. Investors who panicked and went to cash trying to time the bottom (not you, dear reader) should immediately return to their investment plans and buy diversified, good quality stocks.
Again, check your portfolio against the established investment plan and rebalance any asset allocations that are out of whack. Then sit back and relax, knowing the worst is over.
THE ROARING BULL
At this final stage in the overall cycle, the bull market is well established. Economically, statistics show strong growth, falling unemployment and increasing corporate profits. Stock prices are rising. As this cycle progresses and investors grow more confident, greed sets in and they feel invincible.
This is the time to be alert for the temptation to over-weight a portfolio with stocks, especially growth stocks and aggressive small caps. Towards the end of this cycle, market volatility intensifies and quarterly company reporting becomes less predictable, leading to both spikes and drops in stock prices.
Approaching the next market top, once again review one’s holdings against the investment plan and trim the hedges so you’ll be ready for the next fire sale.
Bottom line, understanding where we are in the market cycle and how to react appropriately is a powerful step to building long term wealth. It’s easier said than done. Advisors with Global Asset Management Company Korea report this as one of the most important aspects of their job. Being objective during difficult markets adds value to all advisor-client relationships.
Have an investment plan and stick to it. This is the key discipline in building long term wealth.
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