CAPE TOWN – On April 24 the FTSE/JSE All Share Index closed at 55 188. Almost exactly four months later, the index closed at 48 359 on August 26.
That is a drop of 12.4%. It is however still above the level of 47 092 reached at the last market dip in October last year.
Phrases such as ‘panic selling’ have been thrown about as share prices have fallen. As the below table shows, some big counters that have been market favourites for the last few years have been part of the pull-back:
|Share performance to August 26 2015
|30 day return
|90 day return
The obvious, and common, reaction to falling markets is that people see the value of their investments going down and fear that they are losing money. Common sense would suggest that this is a bad thing.
However, unless you are already living off the capital of your investments or are very close to needing to do so, you should probably be cheering on the market correction and hoping for more. If you are currently accumulating capital or even if you are investing for income, the cheaper you can buy into the market, the better.
Here are two vital things to keep in mind when markets are falling:
1. You haven’t realised either a loss or a gain until you sell your shares
This concept is a difficult one for many people to understand, but it is critical for long-term investors to appreciate. Since the market is constantly moving, what your shares are worth is constantly fluctuating. However, shares only have a realised value once you actually trade them.
To explain this, it is best to think about investing as it was done 100 years ago, when one would be issued with a share certificate. Say you bought five shares in Anglo American, which would currently cost you about R700, and in return you were given a piece of paper acknowledging your ownership.
You can’t take that certificate and buy groceries or airtime with it. It only has value once you take it back to the stock market and try to find someone who is willing to buy your shares at an agreed price.
Whether the share price moved up or down in the interim is immaterial. The only thing that matters is what you were able to sell your shares for at the time you wanted to sell them.
It obviously follows that if you are saving for your retirement that is 20 years away, a 15% drop in share prices now is not a realised loss. What matters is where share prices are in 20 years time when you actually need to use the money.
2. When markets fall you are buying your future income cheaper
All investing is about putting some of your current income towards a future goal. If what matters most is the future value of your investments, what is next most important is how much it costs you to buy that future value.
This can be explained with a very simple example. If you knew that in ten year’s time you could sell a painting for R1 000, would you rather buy that painting today for R700 or R500?
The answer is obvious, and the same principle applies to shares. When you are investing, you are effectively buying future value. The more cheaply you can buy it, the better.
It might make you feel good to see your investments going up as they have done over the last few years, but if you are putting away a monthly amount this is not actually ideal. You want markets to return to more normal or lower levels where you are able to buy at reasonable, or even cheap prices.
This principle also doesn’t only apply to investors wanting to grow their capital. It also matters for those looking for income through buying shares that offer good dividend yields.
Take MTN as an example. The last dividend it paid was R4.80. It doesn’t matter how much you paid for your MTN shares, each one you owned would have paid you R4.80.
So if you think of buying shares as securing an income, falling share prices present an opportunity to buy that income more cheaply. Whether you bought MTN a year ago at R260 a share, or if you bought it today at around R170 a share, you will get the same dividend. And it’s quite obvious which is the better buy.
Part of coming to terms with this is that people who talk about the markets always use positive terms when it goes up and negative ones when it goes down. This is largely informed by our own loss-averse psychology, but it actually paints a distorted picture of what is most beneficial to investors.
We all enjoy seeing markets going up and the value reflected on our statements going up. It’s nice to feel richer. But, actually, the the long term investor should be most in love with the market when it falls.
Article credit: http://www.moneyweb.co.za/moneyweb-opinion/columnists/thank-goodness-for-the-market-correction/#.Vd7lO8hxkT4.twitter