Why do stock prices fall? Various factors are involved, but in a nutshell, prices drop when more people want to sell stocks than buy them. Conversely, the more people who buy a particular stock, the faster that stock's price will rise. If you've studied basic economics and the law of supply and demand, you've already got a pretty clear sense of why stock prices move the way they do. And yet, while the process sounds fairly logical, the behavior of many investors isn't — which gives you some good investment opportunities right now.
To understand why so many investors have acted in a way that may be counter-productive, let's look at consumer behavior in another context. Suppose a hypothetical couple, Mike and Mary Ann, bought a house five years ago for $200,000. They liked everything about the house, and it was the right size to meet their family's needs for many years to come. However, the sharp decline in the housing market has caused Mike and Mary Ann such concern that they decide to sell their house, even though they can only get $160,000 for it. By selling now, they reason, they can avoid further drops, and when the market stabilizes, they can buy another house in the same neighborhood.
To sum up: Mike and Mary Ann took a $40,000 loss on a house they didn't even need to sell. In essence, they were betting that the housing market, against all historical evidence, would not recover enough to compensate them for staying put. Most people would question the rationality of this type of behavior. Yet many of these same people do the same thing when it comes to investments.
Specifically, over the past year and a half, they have sold investments — even quality investments — that still met their needs for growth, income or a combination of both. And when they've sold these investments, they've taken losses — sometimes, big losses. Just like Mike and Mary Ann, they thought they must sell now to avoid bigger setbacks later.
Don't make that mistake. If you weren't planning on selling your investments before the market decline, why sell them now, when you'll just be locking in a loss? Many successful investors hold the same investments for 20, 30 or 40 years — in fact, sometimes they pass these investments on to their children, who also hold them for decades. Are you so sure that your investments, which may indeed have declined 40 percent or more over the past couple of years, won't recover those losses and climb to new heights in the years ahead?
You may someday need to sell, but do so for the right reasons — a change in your goals, a need to rebalance your portfolio or a fundamental change in the companies in which you've invested. In the meantime, not only should you hold on to the investments that that still meet your needs, but you should also consider adding new investments while the price is so low. The more shares you own, the better your financial position will be when the market turns around.
This type of behavior takes patience, discipline and faith in our markets. But over the past century, the investors who have demonstrated these traits have been well rewarded — and there's no reason you can't attain the same results.
This article was written by Edward Jones and was provided for publication by financial advisor Susan Friedrich. She can be reached at 432-7755.