The stock market has been very volatile lately, which is a polite way of saying that stock prices have declined. What should we do?
Good advice remains the same: Maintain a diversified portfolio and focus on your life goals — retirement savings, education of children and grandchildren, and bequests to family and charities. Following good advice is not easy, however, because thoughts and feelings prod us to dump our stocks because their prices have declined.
Why do stock prices go up and down? Think of the prices of stocks and other investments as the outcome of struggles over a steering wheel by two kinds of drivers: fundamentals and sentiment. Fundamentals drivers steer prices by economic fundamentals such as the price of oil, the state of the Chinese economy and the actions of the Federal Reserve. Sentiment drivers steer prices by their emotions. Exuberance and high gains turn sentiment drivers bullish and steer prices higher. Fear and losses turn sentiment drivers bearish and steer prices lower.
The difficulty in identifying the drivers of prices when it matters underlies the failed attempts to profit by timing the market. We see clearly now that we could have profited by selling stocks in late 2007 when sentiment drivers were excessively bullish. But we did not see it as clearly then, when it mattered. We see clearly now that we could have profited by buying stocks in early 2009 when sentiment drivers were excessively bearish. But we did not see it as clearly then, when it mattered.
We might turn out to be right if we dump our stocks now, but the consequences of being wrong can be devastating. We might miss our life goals – retirement savings, education of children and grandchildren, and bequests to family and charities. This is why good advice remains the same: Maintain a diversified portfolio and focus on your life goals.