Overview
How many times have you gone onto a financial news outlet and saw people decrying an impending market crash, simply because indices were down that day?
I know that I’ve seen that on several occasions, and every time I do it only ends up leaving me slightly agitated. If I had a dollar every time I saw a news article with some doomsday headline simply because a major index lost a couple hundred points, I’d probably have enough money to buy the shares of every company in the S&P 500.
There are a lot of odd things you’ll come across as an investor, but the thing that still perplexes me is why so many investors stress out over the daily movements of market indices, then proceed to make wild conjectures about those movements.
A Reminder of What a Market Index Is
I’ve previously explained what a market index is, but to summarize, they are essentially a basket of stocks that serve to represent a specific industry or part of the broader economy.
For example, the S&P 500 is comprised of the 500 largest corporations in the United States and is widely considered an indicator of the U.S. economy’s health. Whenever the S&P 500 is reaching all-time highs or lows, people are quick to associate that movement with the health of the U.S. economy at a given time.
Market indices are used to guide the portfolio composition of an index fund and serve as a litmus test for the economy. Whenever a news article says, “market is down”, almost always it is referring to a major market index.
The Fallacy of Extrapolation
Although market indices are closely followed by many investors, some investors have mistakenly conflated “market index” and “the economy” as being the same thing.
Because market indices are the closest tool we have to measure the health of a country’s economy at any given moment, when an index drops, many investors interpret that as the entire economy going down the drain. Let’s take a few steps back, shall we?
In science, when a sample is taken and an observation is made, the thought process is: “if this behaviour/trait was observed in the sample, then we can reasonably assume that a sizeable portion of the population should also have this behaviour/trait.”
If 100 bears from a population of 1000 are found to have a disease, then chances are some of the other 900 have it as well. This is just simple extrapolation.
The problem with extrapolation is that a lot of assumptions need to be made, the biggest one being “if something has repeatedly been observed in the past, it is bound to happen again in the future.”
We are all good at pattern recognition, it’s simply human nature. If we observe the same phenomena hundreds of times in the past, we’re inclined to believe that it will surely continue in the future.
My investing experiences and personal study have taught me a lot, and one of the insights I’ve gained is that any sort of extrapolation related to investing should always be taken with a huge grain of salt.
Any experienced investor knows that the world of investing consistently stands in stark contrast to common sense and human logic. What makes sense to the average person may seem ludicrous in investing, and vice versa.
When a market index declines because a select few companies have declined, an investor must resist the urge to extrapolate and assume that every other company in that industry or the broader economy is also in decline. The actions of the few do not dictate the actions of all.
Each business has its own nuances, so making a blanket assumption about an entire industry simply based on the actions of a few, arbitrarily selected companies isn’t the greatest idea.
Evaluate on a Case-by-Case Basis
Before proceeding to panic sell simply because an index has declined, it may be worth your time to double-check if the companies in your portfolio truly have been affected.
Throughout 2020, there was no shortage of news headlines declaring that some industries such as airlines and oil and gas were going to fail any day, but such headlines are usually just blanket assumptions and don’t account for the nuances of every company in that industry.
I have come across countless articles declaring that oil and gas is dead, but every time I reassess my sole oil and gas holding, Enbridge, after evaluating the facts of the matter I find that there is no need for me to panic. Again, just because a few, high-profile companies are in decline doesn’t mean their peers are declining as well.
Ever since the COVID-19 pandemic started, banks have been under close scrutiny because a lot of people fell on financially hard times, leading to loans not being repaid on time, if at all. This forced banks to respond by increasing their provisions for loan losses.
In mid-2020, Canada’s major banks set aside $11 billion for loan-loss provisions, an unparalleled number. This signalled that banks were preparing for the worst in case their loan portfolios suddenly imploded. Naturally, financial markets interpreted this as bearish, driving the stock prices of Canadian banks down, and kept them down for the remainder of 2020.
Almost every retail and commercial bank (all of Canada’s Big 5 banks have retail and commercial banking operations) breaks down the loans they lend to people and businesses in their annual reports. In Canada, a bank’s total loan portfolio is usually broken down by province for personal loans, and by industry for business loans.
The province that consistently had higher than average loan defaults was Alberta, attributed mostly to a struggling oil and gas industry. The only Canadian bank I hold is TD, and their loan exposure to Alberta and the oil and gas industry isn’t so large that it warranted any major concern.
Although many people were bearish toward banks and the financial services industry in 2020, all it took was a bit of skepticism and some analysis to dispel the pessimism. Instead of seeing all the bad news and assuming every Canadian bank was doomed, I did my own detective work and found out that things weren’t as bad as they appeared.
Wrapping Up
Market indices play their role in the investing ecosystem, but investors would be wise not to conflate “market index” and “economy.”
Just because a market index goes down doesn’t mean every company is suddenly going to close shop.
The next time you see market indices in the red, take a breath and double-check whether the companies you own have actually been affected, or whether it’s just noise with no valid reason to be concerned. There is no need to stress over market index activity.
Photo Attributions
