Investing in Challenging Times, Term Paper Example

The recent decline in stock market has been accompanied by massive sell-offs as has been the case historically. On August 4, 2011, Dow Jones plunged 513 points which was its worst one day decline since October 2008 (Alden, 2011). A better investment strategy is to buy stocks during market declines rather than selling them and most investors do exactly the opposite of what they should be doing. This is because stock markets are influenced by human emotions which have nothing to do with the fundamentals of the underlying stock. Some of the most successful investors are able to resist the group mentality which is often behind high volatility in the stock market and do not let the market noises affect their investment strategies.

In theory, a stock is supposed to represent the underlying value of the company. When stock markets decline, the massive sell-offs result in lower prices in line with the laws of demand and supply. But these new lower prices are misleading because companies’ fundamentals do not change as frequently as the sentiments in the stock market unless the industry is in permanent decline or there is a huge mismanagement of the business. Because the companies are affected by economic conditions, temporary performance disappointments are more a reflection of the underlying economic climate rather than the fundamentals of the companies.

Investors should apply the same criteria to stocks that they apply to other items. When products go on sale in the retail store, consumers find the prices more attractive and increase their demand. In fact, items go on sale because the stores know that reducing prices will help increase the demand. Lower prices do not mean that the underlying quality of the items has decreased. In fact, those whobought the items when the demand was still high got lower value than those who buy the same item at discount. Similarly, sound investment strategy is to buy the stocks at lower prices during market declines rather than when they are still in vogue. Those who buy stocks during market declines have more upside potential than those who buy it during boom times at higher prices.

Buying amidst the stocks sell-offs doesn’t only sound logical but has also recommended by the world’s most renowned investor Warren Buffet. Buffet remarked in his opinion column in The New York Times, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors.” (Buffet, 2008). Buffet went on to say that fears regarding the long term prosperity of sound American companies made no sense. Many investors also make the mistake of selling stocks at losses that they initially purchased at higher prices. Investors who have done their work see stock market declines as an opportunity to add even more to their existing portfolios because they know that the stock prices will eventually recover to reflect the underlying values of the stocks. The realization that stock markets do not always act rationally is leading to the popularity of a new field called behavioral finance which proposes psychology-based theories to explain stock market anomalies (Investopedia).

Thus, investors should not assume that stock markets are efficient as is preached in the academic and that stock market declines reflect falling values of the underlying companies. Investors should do their homework because stock market declines offer better buying opportunities than stock market booms or normal market conditions. Emotions often lead to disastrous performance in the stock market which is why investors should panic during declining stock markets.

References

Alden, W. (2011, August 4). Dow Jones Plunges 513 Points, Suffering Worst Single-Day Drop Since October 2008. Retrieved August 30, 2011, from http://www.huffingtonpost.com/2011/08/04/dow-jones-industrial-closes-down-513-points_n_918796.html

Buffet, W. E. (2008, October 16). Buy American. I Am. Retrieved August 30, 2011, from http://www.nytimes.com/2008/10/17/opinion/17buffett.html

Investopedia. (n.d.). Behavioral Finance. Retrieved August 30, 2011, from http://www.investopedia.com/terms/b/behavioralfinance.asp#axzz1WZesr71r