15 September 2020
In the hope of assisting investors to make better sense of the current financial climate, I would like to assist by explaining some of the financial jargon that is often used during market downturns.
While it is impossible to control what happens in markets, you can make sense of these events by gaining a better understanding of the financial jargon that gets thrown around.
The term “recession” in its strictest definition means that an economy experiences two consecutive quarters of negative economic growth as a result of a significant decline in general economic activity.
During a recession, businesses experience less demand (i.e. they sell fewer products and/or services). These businesses usually react to this by cutting costs and sometimes laying off staff to protect the profitability of the business. When staff are retrenched, this leads to higher unemployment rates.
Generally, a recession does not last as long as an expansion does. Historically, the average recession (globally) lasted 15 months, compared to the average expansion that lasted 48 months.
A bear market is when a market experiences a decline of at least 20%, usually over a two-month period or longer.
Bear markets often arise from negative investor sentiment because the economy is slowing or due to the expectation that it will slow down. Signs of a slowing economy may include a decrease in productivity, a rise in unemployment, a decrease in company profits and lower disposable income.
When someone talks about having a “bearish” view, it means they have a pessimistic outlook.
Markets have been highly volatile of late, meaning equity prices have bounced up and down rather severely from one day to the next. Volatility marks how much an investment’s price rises or falls. If an investment’s price changes more dramatically and/or more often, it is considered more volatile.
Price volatility is usually expressed in terms of standard deviation, or how much an investment’s price has fluctuated around its average price over a certain period. A higher standard deviation implies an investment’s price is more volatile.
Investments with more uncertain outlooks, like equities, are typically more volatile, because equity returns are based on a company’s profitability, which is difficult to predict. In uncertain market environments, like the current one, investors tend to be especially pessimistic about how businesses will perform, which can result in steep market declines.
So, why would you want to invest in a more volatile investment? Because you are likely to be rewarded with a higher return over the long term.
Volatility and risk are terms often used interchangeably, although they are vastly different. Risk should be defined as “permanent capital loss” or the chance that you will not meet your financial goal.
For a retiree, one risk might be not taking on enough risk. By reducing your exposure to more volatile or “risky” assets such as equities, you could significantly limit your portfolio’s potential return over the long run. By remaining invested in cash for prolonged periods of time, you run the risk of increasing your tax bill significantly (due to interest earned being fully taxable) or losing purchasing power due to the eroding effects of inflation.
So where does that leave investors? Things might not be so hopeless after all. Recessions, bear markets, drawdowns and volatility are all part of the world of investing and building long-term wealth.
Acknowledgement: Kirk Ridgway