If you listen to people in finance, every time the market gets a little crazy, they always tell you to focus on the long term. They say it’s the fundamentals that ultimately matter. If that’s all true, which it is, then why do markets freak-out every so often?
It’s because the people who cause the volatility generally aren’t the ones who are working with individual investors and families. The ones shoving the markets around are behind the scenes. They are engaged in high-risk activity that they really don’t want too many people to know about. And when it gets ugly, they are unlikely to raise their hands and say “Oops, my bad.”
But their trading activity dominates markets when things get volatile. Why? Leverage. Leverage is a term in finance that means you are using borrowed money to wager on market moves. And when the market moves the “wrong” way, the leverage (borrowing) magnifies the damage and leads to the frantic behavior.
The easiest way to think about this is to relate it to your home mortgage. To make the math easy, let’s assume you bought a $1 million house and put down 10 percent, or $100,000. You have a 30-year mortgage for $900,000, and your obligation is to just keep paying that monthly mortgage. If you do that, the house is yours. Now, if we hit a recession next year and the value of your house on paper falls to $900,000, you don’t have to worry about anything because all you need to do is keep paying your mortgage. You don’t intend to sell the house during the recession, so ignore it. Things will recover and your house will go back to appreciating.
Now, let’s say that instead of borrowing $900,000 on a 30-year mortgage, you borrowed that $900,000 on a one-day mortgage. That means every day the bank can require you to repay the mortgage in full. Why would you do that? Because borrowing short term allows you to pay a very low interest rate. As long as the value of the house is about $900,000, the bank could care less and they’ll keep renewing your loan every day. But, if the value falls to $900,000 or less, they can require you to pay off the mortgage in full.
Now, when the recession hits, you have a big problem. If the house falls just 10 percent in value, then you lose 100 percent of your $100,000 investment, since the bank may require you to pay back the loan by selling the house. This is leverage. If you had paid cash for the house, had no mortgage, then the price decline is not a problem if you aren’t selling.
Instead of a house in this example, just substitute stocks. You bought $1 million worth of stocks and only used $100,000 to do it. The bank loaned you $900,000 to buy the rest (at a very low interest rate). Congratulations, you have a $900,000 one-day loan that can be called at any time. So if the market falls just 10 percent, you are looking at a 100 percent loss on your $100,000 investment. That’s why many traders panic on what look like small market moves to you and me.
If you aren’t leveraged, you don’t need to do anything. If you are, you better stop the bleeding, and often the only way to do that is to sell before it gets worse. As you saw over the last few weeks, markets can move 5 percent pretty fast, so if you want to avoid big losses getting bigger, you often have to sell.
You might wonder, well who would do such a crazy thing? Consider the same example but the market goes up 10 percent, and now your account is worth $1,100,000. But, you only actually invested $100,000, so you quickly doubled your money on a 10 percent market move. That’s why people do it. They use leverage to make more from financial market returns than can be supported by the fundamentals. And when it reverses, they lose more than what might be justified by the fundamentals.
If you aren’t engaged in making leverage bets on the market, then you really can ignore these sharp moves up and down. I realize it’s hard to do since the information can be overwhelming, but time and time again, those who remain calm and make sound investments based on fundamentals do just fine. Let the leveraged people stress out, while you work on your golf game, go skiing or do yoga, all of which are more productive than watching stock prices.
Charlie Farrell is a CEO of Northstar Investment Advisors LLC, and guides the firm’s investment philosophy. He is the author of “Your Money Ratios: 8 Simple Tools for Financial Security.” This article is for information and education purposes only. It does not constitute investment, tax or legal advice.