A few weeks ago, the markets saw a decline in share prices that was not seen for some time. For some investors, this could have been a big loss, while for others it could have been an opportunity to make a profit. Deividas Urbanovičius, Head of Investor Relations at InRento, a crowdfunding platform for buy-to-let property projects, explains how to react to such changes and what strategies help to turn them to your advantage.
On 5 August, Japan's Nikkei 225 fell by more than 12% in one day, its worst performance since 1987. The S&P 500 share index of the largest US companies fell by more than 3% and lost USD 1.3 trillion. This downturn once again proved an important rule of investing: financial market fluctuations are inevitable and investing always involves risk.
This time, the sell-off was triggered by the simultaneous occurrence of rather pessimistic circumstances, such as worse-than-expected earnings growth forecasts for companies in the technology sector, a drop in activity in the US labour market, and the Bank of Japan's hike in interest rates. However, such a sharp and relatively short fall is more due to psychological factors, the high levels of stock prices and the forced closure of positions when investors use leverage, i.e. borrowed money.
Turning to Japan, for many years, the country's near-zero interest rates have made it common for investors to borrow cheaply, at minimal cost, and invest the money in higher-yielding assets such as shares in US technology companies. However, as the Bank of Japan raised interest rates and the yen strengthened against the US dollar, the profits from such deals fell. This prompted investors to sell their equity positions abruptly, accelerating the decline in the country's leading indices.
These and other similar market downturns can be very worrying, especially as it is not always possible to predict when they will happen. Over the last 25 years, we have seen at least three huge market downturns and a series of more minor corrections.
After the dot-com bubble burst in 2000, the NASDAQ Composite Index fell by almost 80% in two years. During the global financial crisis of 2007-2009, the S&P 500 Index fell by around 57% and took around five years to recover. Meanwhile, the COVID-19 pandemic in March 2020 will lead to a decline in the S&P 500. The S&P 500 fell by 34% in 2020, but the market recovered in August.
Loss or opportunity – depends on the investor
The decline in share values can create psychological challenges for investors and new opportunities. One of the most significant risks investors can face during a downturn is anxiety-induced selling (closing a position). When the market starts to fall, fear can overwhelm even the most disciplined investor and lead them to sell assets at a loss to avoid a perceived further decline in share values.
However, this reaction will mean recorded losses and prevent investors from reaping the benefits when prices rise. From a rational rather than an emotional point of view, downturns can also create opportunities—falling share prices allow investors to buy at a discount, enabling them to profit when the market recovers. For example, investors who bought stocks at discounted prices during the 2020 COVID-19 pandemic eventually reaped spectacular returns when markets recovered. Not everyone can take advantage of opportunities in such extreme situations.
A diversified portfolio helps keep a cool head
Another risk factor is a portfolio that needs to be more diversified. A portfolio concentrated in just a few sectors or stocks is more vulnerable to downturns than a portfolio spread over a wide range of investments.
For example, when the dot-com bubble burst in the early 2000s, investors who had invested mainly in technology companies suffered significant losses as their shares plummeted. Diversification spreads the risk across different asset classes, sectors and regions, thus protecting against larger aggregate losses in the event of a downturn in one of them.
A well-diversified portfolio can turn downturns into opportunities, and investors with it are less likely to panic and can make more informed decisions. Including relatively stable assets in a diversified portfolio, such as bonds or investments in buy-to-let projects, can also help provide better protection against volatility.
The long-term perspective is important
The lack of a long-term investment strategy also increases the risk of losses. Investors who do not have a clear long-term investment objective and a plan to achieve it may stop investing when asset prices fall on the markets.
A long-term strategy helps to avoid panicking during corrections or crises. By sticking to a long-term plan, investors can take advantage of lower prices for investment products and ultimately increase their portfolio's growth potential over time.
What to look out for when investing
To avoid the adverse effects of downturns, regularly review your portfolio and assess whether it is sufficiently diversified according to your risk tolerance. General investment practice suggests that it is worth reviewing and adding to your portfolio with "cheaper" products during downturns, but the key is to realise that even a "cheaper" investment may not yet have reached its price floor.
In addition, investing in assets that generate recurring income – for example, through a crowdfunding platform for buy-to-let projects – can provide greater stability and steady income and help to mitigate risk in volatile periods.
Also – keep a long-term investment perspective. Investing for at least a few years will minimise the impact of temporary downturns on portfolio growth.
Finally, keep learning, keep updated with financial and economic news and develop your financial literacy.
Regularly studying market trends, economic indicators, and investments will improve your ability to analyse market developments objectively and react to them rationally rather than based on emotions. In the long run, this will give you more informed confidence in managing potential risks and identifying new opportunities.
