The stock market can seem like a scary place. But just like most things we’re afraid of, understanding how it works can help us realize there’s actually nothing to fear at all. In fact, investing is our best shot at growing our wealth over time and being able to cover all the costs of living the life we want.
The good news is that we don’t need to hit “expert” status to invest smartly. Learning these simple concepts can provide a great foundation (and, hopefully, some peace of mind, too.)
What are "market cycles"?
They’re the regular ups and downs you can expect to experience when investing. Mind you, they might not always feel so regular—when stock values drop sharply, for example, it’s common to feel a little panicky. But that movement is normal, even though nobody knows for sure where exactly the market is in its cycle at any given time. That’s why successfully timing the market (or frequently buying and selling to game higher returns) is so difficult.
Why do stock prices jump around so much?
Many people have to take the blame of that one. Investors—including “institutional investors” (entities like hedge funds and insurance companies that pool and invest money on behalf of members) and, to a lesser extent, individuals—push stock prices up and down with each buy and sell order. And often, we follow one another when making investment decisions, which means everyone may decide to buy the same stock or type of stocks and drive prices up, or they might all sell in reaction to bad news and bring prices down.
What could spark that first move? People can be influenced to trade based on a good or bad earnings report, political strife, new products, new competition, technological advances, fashion trends, weather reports—really anything. So, again, it’s impossible to predict where stocks will head next.
What’s a correction?
Technically, it’s when a major index, such as Standard & Poor’s 500-stock index (which tracks the performance of 500 large-company U.S. stocks), falls at least 10 percent below a recent high. The idea behind calling such loss periods “corrections” is that sometimes stock prices head higher than experts think they’re worth at the time, and the drop “corrects” that overpricing. Corrections have been known to occur every year or two, depending on how you slice the data.
What are bear and bull markets?
They’re the major components of market cycles. Here’s an easy cheat sheet: bear = down, bull = up.
More specifically, a bear market is generally defined as a period when major indexes drop by 20 percent or more from a recent peak. Conversely, a bull market is more loosely defined as a period of consistently rising stock prices.
Since 1926, we’ve seen the alternating pattern of bears and bulls, with eight bear markets and nine bull markets, including the current one. You probably remember the last bear market, when the S&P 500 tumbled by more than 50 percent between October 2007 and March 2009. (But it has more than tripled in value since that bottom.)
According to First Trust Advisors, each of those bears lasted just 1.4 years and lost a total 41 percent, on average. That might sound harsh, but bulls, on average, have gone on for 9.1 years and gained a whopping 480 percent. Historically, bulls have prevailed, and the general direction of the stock market over the long term has been up.
Can I lose all my money with stocks?
While a single stock can lose all its value—for example, a company might declare bankruptcy—the overall U.S. stock market has never.
That’s exactly why diversification is so important, even within just the stock portion of your portfolio. For starters, you should have good mix of smaller and larger companies and international and domestic stocks. In normal market cycles, some of those stocks should go up while others go down, mitigating losses across your entire portfolio.
What do I do when the market drops?
Don’t panic. Remember that market cycles, including drops, are par for the course. Your long-term investment strategy should therefore be ready for any falls.
You might even be ready to take advantage of inevitable periods of loss and buy stocks you’ve been interested in when prices are cheaper. But just like you don’t want to sell out of fear, you also don’t want to buy out of greed. Emotions should not dictate your investing moves in either direction. The best thing you can do is stick to your investing plan.
What can I do to protect my money from large market swings?
Diversify, diversify, diversify. Beyond your diversification within stocks, you may also incorporate corporate and government bonds and real estate into your portfolio.
Also don’t forget good ol’ cash. If you have enough cash on hand, like in an emergency fund, you’ll be more likely to let your investment dollars ride regardless of what the stock market is doing at any given moment. And the longer you can stay invested, the more likely you can make market cycles work in your favor as you’re marching toward hitting your financial goals.