Corrections and the nature of markets. By Nick Crawford.


In October, volatility reappeared in the investment markets after an unusually long absence. We therefore thought we should remind you that we are here to help you make sense of the events of last month and help you stay focused on your long term financial goals and not get too concerned about the vagaries of the market.

Markets around the globe have been falling due to worries ranging from trade policies and tariffs to rising U.S. interest rates to geopolitical concerns. Rather than be alarmed, however, we should consider whether this is merely a return to more “normal” conditions, not necessarily a harbinger of worse to come.

Why do we say a return to more “normal” conditions? First, let’s think about the nature of investing and the relationship between risk and return. Furthermore, recall that risk and uncertainty are related and with more uncertainty, the potential for future payoff may also be greater.

We have all been vulnerable to forgetting the nature of risk and uncertainty of investing, especially as markets have been rising since March 2009, with just a couple of corrections in between.

For with higher expected returns, we must expect, and perhaps welcome, volatility, as that is the mechanism through which investments ultimately find their true value. When discussing corrections, we must consider three basic issues: 

Why they exist, why they are natural, and why they are necessary. 

Corrections exist because facts become more widely known and understood, or alternatively, they change altogether. News flows are constant and are almost always unpredictable. Random events confound even the most carefully-made forecasts, which then must be discarded. Conventional wisdom is re-examined, and new data provides investors with different ways of thinking about an investment, or even the markets as a whole. Armed with fresh knowledge, investors may respond with “sell” instead of “buy.”

Corrections are natural because the data does change and people, in turn, change their minds in response. In a static world, there would be no corrections – nor would there be many opportunities, either. In that world, all investments would always be priced at their “fair value” and would never deviate in a way to provide an entry point to buy a new opportunity. Investors constantly research, analyse, and evaluate investment opportunities. Information on those opportunities is constantly being released and thus is constantly changing. Being early to capitalise on that changing information means some investors are quick to act – and when they all act at once, then the market may either surge higher or plunge lower.

Corrections are necessary because it is through this mechanism that risk is fairly priced. What do we mean by this? Quite simply, stocks, bonds and other investments are determined by what investors are willing to pay for them; this depends in turn on what people expect will happen in the world. The more uncertainty there is, the lower the price one is willing to pay for an investment, because there are more ways that the investment can be pushed off course. 

In this situation, most investors want more protection when buying a stock – and that means a lower price. A correction, thus, is a way in which a sign that says “Special! On Sale!” is hung over the market, perhaps signalling buying opportunities. Indeed, it’s often the time when many investors go shopping for things they might not otherwise have bought when they were more expensive. It’s simply how the market works, much as in a department store.

In fact, it’s abnormal not to have corrections. We’re quite overdue, in fact. Having one, or even more of them would be a return to normal. In this case, “normal” means an environment with more volatility; that is, the very thing which investors undertake to receive the returns they expect. It’s a natural, expected, and customary trade-off.

Having discussed the nature of a correction, what does it not mean? For starters, it generally isn’t anything to be overly concerned about, for reasons we just explored. It also doesn’t necessarily signal any broader problems with the market or the economy. We can – and often do – have a solidly growing economy and corrections that occur in the midst of those expansions.

What a correction in the current environment might mean is that investors looking under the surface discover there actually is uncertainty in the world, after all. This is true even if reasons for optimism about the economy abound. And since there is always plenty of uncertainty in any environment, you will probably see more ups and downs going forward.

We know the markets can be volatile in the short term, but this is already factored into our long term strategies. 

The worst decisions long term investors can make is to try to time markets or react to short term volatility, as this can jeopardise the achievement of your long term goals.

So, our strong recommendation in volatile times is to stick to your plan unless your circumstances (unrelated to volatility) have changed such that your plan needs to be updated. 

If you are still concerned, we want to talk to you. Our door is always open.