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The IC guide to market behaviour

Understanding stock market trends can help you become a better investor
The IC guide to market behaviour

Key Points:

  • Stock markets rise and fall, driven by the demands of investors
  • Those investors are a predictable bunch, which means that stock markets behave in predictable ways.

1. Investing in a bear market

Glossary: In a bear market, company share prices are falling, thus encouraging more selling. Markets reach official ‘bear territory’ when prices have fallen more than 20 per cent from recent highs.  

The sea of red that lights up global stock exchanges during a bear market is a terrifying sight for investors. Rational thinking and careful management of your portfolio are the best ways to avoid the panic and mitigate the risks of a prolonged sell-off. A sure way of cashing in your losses in a bear market is by selling your assets when the prices are falling.

Beyond the suggestion that it is best not to panic sell, your course of action depends on your age and investment priorities. Those with short-term saving goals might want to mitigate their potential losses by moving their investments into less risky asset classes.

For long-term investors, bear markets can provide an opportunity to pick up bargains. Being fully invested at the end of a bear market makes for spectacular success – but don’t fool yourself into thinking that you can predict the end of the bear market. It is best to be prepared to stomach some early-stage pain as markets continue to fall. To avoid the crushing disappointment of picking a stock that never emerges from a bear market, look for those with strong fundamentals. Common sense suggests that drip-feeding your portfolio will allow you to benefit from recovery in the long term even if prices have not reached their nadir.

"Reasons to be cheerful" - Chris Dillow, March 2020

Amid the brutal coronavirus crash, our economist explained why these tough times can provide opportunities - after all, they have done so before.

“Lessons of the Bear Market” – Chris Dillow, October 2019

Our economics columnist highlights key lessons from a slow few decades for British equities.

Key ratios for bear market investing – December 2009

In the wake of the last major market sell off, the IC looked at ways investors could work out whether the market was cheap and how to find companies that might survive the recession. The lessons still apply today.


2. Investing in a bull market

Glossary: In a bull market, assets enjoy a steady rise. While bull markets are partly based on confidence and evidence of growth, they are also hinged on investor psychology – when there is plenty of confidence, investors keep buying, sending prices higher.

The easiest way to profit during a prolonged period of growth is to buy cheap funds that simply track entire markets or indices. During the bull market run between 2010 and 2020, prolific stock-picker Warren Buffett bet that he could beat a host of active fund managers simply by investing in an index fund. He won his bet by a large margin.

Careful stock-picking of high-growth assets can help investors beat a bull market, but there is more risk involved and individual stock-picking is significantly more expensive than simply buying an entire index via a tracker.

It is also worth being wary of the factors that could cause an end to a bull market. That means regularly taking stock of your investments and assessing the outlook.

“Can US shares keep on delivering for investors?” – Phil Oakley, December 2019

Phil Oakley examines the characteristics of the US stock market during the longest bull run of all time.


3. Investing in a bubble

Glossary: Financial market bubbles are much easier to identify in hindsight – once the bubble has burst. They occur when investor excitement about certain markets is unfounded by financial metrics.

The problem with investor optimism during a bull market is that it can lead to a bubble, where asset prices become overly inflated. An over-inflated bubble will eventually burst and cause a painful sell-off.

To identify an inflating bubble, investors should look for signs of stretched valuations that don’t reflect the intrinsic value of the underlying asset. It is also worth being wary of the economic stimuli or trends that have helped inflate the bubble coming to an end.

Investors who fear an impending crash and want to protect their wealth should assess the intrinsic value of their assets. Low-quality stocks and funds will be the most badly hurt during a crash, while assets with high underlying quality might suffer a short-term blip, but should recover quickly.

The difficulty is not panicking, cashing out too soon and missing out on further growth. So, while it might be best to take profits from the stocks or funds that have grown fast without evidence of underlying quality, there shouldn’t be any danger in staying invested in high-quality equities.

Crash Proof Your Portfolio – Megan Boxall, December 2017

The final few years of the global stock market’s longest ever bull market were characterised by many predictions of doom and gloom. We wrote a guide to identifying the most at-risk assets at the time.


4. What to do in a sell-off

Market sell-offs are overwhelming – even for investors familiar with the long-term nature of investing. Reassuring words about how market corrections like this are part of the normal investing cycle probably do little to ease that feeling of discomfort.

And such discomfort can lead investors to make rash decisions such as selling out of a falling market and buying back in later at a higher price. These mistakes can prove costly for your portfolio, meaning that staying calm is key.

It is important to review the long-term consequences of the cause of the sell-off before making any investment decisions, including dumping shares or attempting to buy the bounce.

What to do in a sell-off – Dave Baxter, March 2020

A run-through of a few simple rules that could prevent you from losing a lot of money during a painful sell-off.

3 ways crashes cause investment mistakes – Algy Hall, March 2020

Why investors behave as they do during times of difficulty and why that could be a bad thing.

Surviving sell-offs – IC writers, February 2016

How to preserve your wealth and spot opportunities amid the gloom of a major sell-off.


5. Recovering from a crash

The period after a painful crash comes with a great deal of scepticism and uncertainty. Wary investors might be inclined to stay away from equity markets in favour of the perceived safety of cash or bonds. But getting back on the horse as quickly as possible is the best way of to make money post-crash.

It is important to consider how the stock market might have changed post-crash and assess the assets in your portfolio for their long-term growth opportunities. Companies that are significantly cheaper than they were a few months ago could prove good investments.

Coronavirus crash: should I start investing now? - Megan Boxall, March 2020

A run through of the key questions you must ponder and tips you should follow if you are trying to get back into the markets after a major sell-off.

Bouncebackability – Theron Mohammed, Harriet Russell and John Hughman, August 2014

How to identify companies that have the ability to bounce back after a sell-off.

Out with the old – Todd Wenning, December 2016

Tips for cleaning out your portfolio.