The Best and Worst of Equity Markets

Posted in: Economics, General, Stock Market, Thought of the Week

Liquidity is Good and Bad

The ability to sell a stock immediately is one of the most attractive components to U.S. equity markets. At any given point during market hours, an investor can sell a large quantity of stock with the expectation that the order will execute within seconds.

This feature is referred to as “liquidity”, and U.S. equity markets are some of the most liquid financial markets in the world. Investing in highly liquid markets allows investors to sell quickly if a crisis emerges and also lowers transaction costs because of the large number of buyers and sellers at any given time.

For example, our DIAS portfolios invest in only the most liquid stocks as a precautionary measure. If these portfolios held stocks that were less liquid, we could run the risk of outsized losses if we needed to exit a position quickly.

Although the ability to value an equity portfolio is one of the best features of our equity markets, it’s also one of the worst. Investors often become far too fixated on the day-to-day movements instead of focusing on their long-term goals.

Short-term volatility is driven by emotions, primarily fear and greed, and rarely do changes in fundamentals impact prices in a single day or week. Instead, relevant trends develop over time so the constant movements of prices in a portfolio on a daily basis tell an investor next to nothing about the actual risk in his/her portfolio.

Implications for Investors

Imagine if you were able to look up home prices in the same manner as stock prices. Meaning, every day you could go to a website, enter your street address, and see the value of your house changing every second.

This fictional world would likely drive many people completely insane since a house is generally the largest component in an investor’s overall net worth. Knowing that your house may move several thousand dollars from one hour to the next would be too much volatility for many investors to bear.

Now there are likely several homeowners out there who would disagree with this analogy for the sole reason that most people buy homes with the intention of living in them for many years. Therefore, daily and even yearly price changes are far less relevant, so a rational homeowner should have no interest in the short-term price movements.

We strongly urge our investors to view their equity and fixed income portfolios in the same manner. As in, treat these investments just as you do your house, and ignore the daily ups and downs because they are irrelevant.

Unfortunately, it’s easier said than done because although liquidity is one of the best traits of our equity markets, it’s also one of the worst. Falling victim to panic selling in equities is far too easy because an investor can sell minutes or even seconds after fear has overcome them.

The bottom line is that we strongly urge all investors who are active participants in equity markets to build and manage portfolios for the long run. Volatility is nothing more than a measure of emotion, and long-term investors simply must ignore it since it bears little to no indication of actual risk in their portfolio.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.