If you're an investor, you probably haven't enjoyed opening your account statements the past few months. In January alone, the Dow Jones Industrial Average fell 4.6 percent. And since the Dow hit its all-time high of over 14,000 in early October 2007, the index has dropped more than 11 percent. So, at this point, you probably have at least two big questions: What's causing this market instability? And how should you respond?
Let's start with the first question. What forces have caused the market drop? Here are the chief culprits:
- Looming recession - Leading economic indicators suggest a significant slowdown in growth. For example, the unemployment rate has risen to 4.9 percent, up from 4.4 percent last March. Since 1949, we haven't seen such a big rise in unemployment without a recession.
- Subprime loan crisis - As you know, the subprime loan crisis has been in the news for months. First, the problems with subprime loans hit the real estate industry and the financial services industry. But now, the subprime crisis may have spread to the extent that consumers are being forced to pull back from spending.
- Decline in international stocks - As a huge part of the global economy, the United States is far from immune to what's happening in foreign stock markets - and many of these markets are down between 20 and 30 percent over the past several months.
So, in a nutshell, these factors have helped lead to the stock market decline. Yet, as an investor, you may have opportunities right now, because many stocks have already fallen 25 or 30 percent. And the decline in stock prices has also meant a drop in the ratio of share prices to company earnings ("P/E"). In fact, right now, the price-to-earnings ratio is pretty low, by recent historical standards.
In plain English, this means that stocks are now relatively "cheap." And yet, strangely enough, investors often stay away from the market when stocks are valued attractively, and only jump in when it's more expensive to buy.
Consider this quote from Warren Buffet, perhaps the world's most famous investor: "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well. The dumbest reason in the world to buy a stock is because it's going up."
So, if you have room in your portfolio to add appropriate investments, look for those opportunities now - but don't buy investments today that you would not want to own in a recession tomorrow. If you are already fully invested, with a diversified mix of quality investments, have the courage to be patient and do nothing. (Keep in mind, though, that diversification does not guarantee a profit or protect against a loss.)
If you've created a long-term strategy - one that is suitable for your needs, goals, risk tolerance and time horizon - stick with it. Bad times don't last - but smart investors do.
