What the Heck is Going On?

What the heck is going on? Stocks are selling off. What is the market doing on sell off days?  A couple things are happening:.

1. Lets say that based on information known to you a few days ago, you owned an investment called the stock market and because of the risk in the market you demanded an 8% return. Therefore, if you owned $100 worth of the stock market you expect to earn $8/year from that stock market investment. This $8 is made up of profits in the form of dividends and growth in the price of the stock market.
Then information on the economy is reported. The new information says the economic future is not as bright as yesterday. That may mean that the expected profits of stocks will be less than expected, so the $8 you thought you may receive is now expected to be only $7.  If you want to sell your $100 worth of stock on the bad day, nobody will pay you $100 because the buyer wants an 8% return, and a $7 return on a $100 purchase is not an 8% return. In order to get that return, the buyer will only buy your stock for an amount less than $100, in fact they may only be willing to buy your stock for $87 ($7 earnings divided by $87 = 8% return).  Thus the market goes down on the bad news day.

2. The second thing that is happening, is people panic. They see the prices going down and they want to protect themselves so they start selling their investments and there may not be as many buyers as sellers on a bad day. Guess what happens then, the buyers demand a better deal from you and further drive down your price.

The crazy thing is that today or Monday or next month, nobody knows, the news could be good and this whole thing is reversed. The markets swing wildly over short periods because day to day buying and selling is based on the news of the day.

This is all bad if you need to sell your stock on the bad days or during bad periods.

But, over long periods of time we do know that news averages out and historically has been positive. That is why the market is higher today than it was 20+ years ago. Stocks have always been like a person with a yo-yo walking up a hill.

Its the2nd item above, the panic selling, that usually drives prices far below their actual future value. That is why buying during a sell off is generally positive over the long term. You are buying shares that are undervalued.

For those who are young and are buying stocks (mutual funds) on an weekly basis in your 401K then you are most likely buying when the market is low compared to where it will be when you retire. Because when the current bad news turns good then your investments will start paying more in the form of higher dividends and market growth.