The stock market is a great place to start with for understanding investment. It is probably the first thing that comes to mind when you think about investing. You’ve probably heard references in the media or in conversation to things like stock exchanges, indices, bull and bear markets, and more. Popularity is growing for these terminologies nowadays as there are so many applications available for investing in the stock market. Maybe these terms sound unfamiliar to you, or you have a vague understanding of what the stock market is.
“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” — Warren Buffett
The Stock Market
The stock market is basically where buyers and sellers trade assets like stocks (also known as shares or equities) and bonds.
A stock represents an ownership share in a company. They are sold by corporations who want to raise capital to fund the growth of their business. Stocks rise and fall in value based on what buyers are willing to pay for them and what sellers are willing to take for them. People make money from investing in stocks either from buying low and selling high or from compounding growth over time based on valuation and dividends earned.
A bond on the other hand is basically a loan that you, the investor or bondholder, can make to a borrower (e.g. the government or a corporation) that is trying to raise large amounts of money. This loan is tied to a maturity date and a specified interest rate at the time you make this loan. As a bond investor, you’d earn money from interest paid over the time based on the bond agreement in place. At the maturity date, you receive your initial investment back as well. It’s commonly referred to as an “I owe you” investment.
As you understood what the stock market is, let’s talk about stock exchanges. While terms like the stock market and stock exchange are commonly used as one and the same thing, they are slightly different. The stock market is more of a general term referring to the entire buying and selling market of stocks, bonds, and other asset types. Stock exchanges are more specifically the actual infrastructure set up to support these trades when they happen. Stocks, bonds, and other asset types are listed for sale and purchase on the stock exchange.
The Economy and The Stock Market
Now, let’s talk about the effect of the economy on the stock market. The performance of the economy has a direct impact on the performance of your investments in the stock market. Whether the economy is growing or in decline (a period usually referred to as a recession), its state at any given time impacts how much money is available and being spent, and also impacts the demand and supply of goods and services. As a result, the economy influences the performance of the stock market, because the companies (businesses) that make up the stock market are also driven by supply and demand.
The performance of these same companies ties into job creation and employment or the lack thereof and influences how comfortable people are with spending money depending on how the economy is doing. In growing economies, there are typically lots of jobs available and people typically spend more money because they feel good that the economy is doing well, whereas in recessions unemployment is higher and people are typically more cautious with the way they spend money due to a higher feeling of uncertainty. Basically, all of these things boil down to what is typically known as economic cycles.
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” — George Soros
The Impact of Economy on Portfolio
A range of investments held by a person or organization is called a portfolio. Now let’s understand the impact of the economy on the portfolio. The behavior of the economy can affect the portfolio in several ways, including:
a. Through Inflation
Inflation is essentially the increased costs of goods and services and the decline of the purchasing power that money has. For instance, inflation can cause the same exact product (like bread or milk) to cost more today than it did five years ago. High inflation reduces the purchasing power of the currency, so $50 now will buy you fewer groceries than it used to. Since high inflation can make it expensive to buy goods and services, it discourages consumers from making as many purchases. This causes companies to have lower sales and in turn less revenue, in which case their stock value could fall.
On the other hand, low inflation means people have more spending power and companies are doing well with sales and revenue, which in turn causes their stock value to rise. This rise and fall of stocks in relation to inflation directly affect your portfolio because if the value of a stock you own falls, your investment is worthless, and if the value of the stock increases, your investment is worth more in turn.
b. Through Changes in Interest Rates
For any country, central banks regulate interest rates to ensure stability and liquidity in the economy. In India it’s being done by the Reserve Bank of India (RBI) & in the United States of America it’s Federal Reserve. These interest rates help determine what it costs to borrow money from your bank, credit card company, or other types of lender, as well as how much interest you’re paid (e.g. in a savings account). Banks and lenders can still set their own specific rates, which is why you will find higher and lower interest rates from different institutions. Typically, interest rates are raised in strong economies to manage excessiveness and lowered in declining economies to encourage spending.
When interest rates increase or decrease, the value of stock prices can be indirectly affected as well. For example, if interest rates are increased, the interest rate on mortgages for prospective home buyers will be higher. In turn, monthly mortgage payments will also be higher. When people have higher mortgage payments, they also have less discretionary income to spend, which can impact the sales and revenues of businesses that are publicly traded in the stock market. In turn, of course, the value of their stock and your portfolio can decline.
c. During Bear Markets
A “bear market” is a term commonly mentioned when the stock market is being discussed. Basically, during bear markets, stock prices are in decline, and this makes investors nervous. (The name literally makes us think of bears hibernating in caves; the economy is just hibernating, too!) A bear market usually goes hand in hand with a flat or declining economy. Often, investors see these declining prices, panic, and sell their stocks, often at a loss, because they’re afraid of further declines. Panicking, however, is not a good idea, especially when you have time on your side and can weather the storm.
In fact, a bear market could present great opportunities to buy stocks that are undervalued. In other words, it could be described as “the stock market on sale,” because when stock prices are lower, you can buy them for cheaper. A bear market is a great time to revisit your financial objectives and make sure they’re right for you.
d. During Bull Markets
This is another commonly mentioned term. If a bear market is hibernating, a bull market is charging. During bull markets, stock prices rise, investors gain confidence because their investments are making money, and as a result, they are motivated to buy, buy, buy. And who doesn’t love that?! Bull markets are typically high-growth times.
When does a bull or bear market occur? Typically, a shift of 20% or more from a recent peak or low can trigger an “official” bear or bull market. So basically, if stocks or indices fall more than 20% over a period of time (two months or more), it’s considered a bear market, and if they rise more than 20% over a given period of time, it’s considered a bull market.
e. During Market Bubbles
In market bubbles, stocks are typically overvalued, and prices of stocks are much higher than they are worth. The bubble eventually bursts, as all bubbles do, and prices fall. Bubbles usually occur with “hot” investments when everyone is rushing to buy and inflating the actual value of the investment. A good example of this was the real estate bubble that burst, causing the 2008 financial crisis and recession due to overvalued real estate, easy access to financing (even when people could not afford it), and a lot of speculative behavior on the part of investors. Investors who buy “hot” investments at the height of a bubble usually lose the most. Unfortunately, the impact of market bubbles in specific industries can trickle into other industries and markets. For instance, the 2008 recession had a global impact. So, when it comes to investing, relying on hot stocks is not the way to go.
Overall, when it comes to the economy’s behavior and how it impacts your investments, the goal is to ensure your overall portfolio is well-diversified and you have clear objectives and a simple yet effective long-term strategy to build wealth regardless of bears, bulls, or bubbles. (Excerpt is from ‘Clever Girl Finance’ by Bola Sokunbi.)
