Monday's selloff in Facebook stock and other big technology companies highlights an important lesson for investors – prices are volatile, and the ups and downs are all part of the investment journey. Selloffs represent an opportunity to buy shares at lower prices, but caution is warranted.

If investors have a long-term investment philosophy, a short-term fall in prices, or even a downturn in prices over the medium-term, isn’t something that will hurt them. It doesn’t feel good, but unless investors sell their shares at the bottom of the market, then a price drop won’t dent wealth over the longer term.

How can an investor take advantage of volatile markets? While there's no way of knowing whether the stock market has further to fall, there is no point trying to pick the bottom, according to Scott Keeley, a financial adviser with Wakefield Partners. He recommends investors put money in the market when they can.

“Many investors will say that they are waiting for periods of extreme volatility to enter the market, but then when it occurs, they either get cold feet or prefer to hold until the market goes lower," he says.

"This paralysis often means that investors miss the opportunity all together.

"We have always preferred a ‘drip feeding’ strategy of investing—making small investments, and making them often, enables the investor to take advantage of the opportunities that market corrections create without trying to pick a single-entry point.

"It is time in the market, not timing the market, that is the key to wealth creation."

That raises an important point. Investors need to be picky about where they invest. While some shares might seem ‘cheap’, they may also be risky. How do investors build their portfolio with quality stocks and avoid the duds? According to Mathew Hodge, Morningstar’s director of equity research, investors should take three factors into account:

  1. The market price of the shares relative to Morningstar’s fair value. If the ratio is below one, then there's a good chance that there will be upside to the shares. However, if it is above 1, then there is likely to be downside.
  2. The Morningstar Rating for stocks, which identifies stocks trading at a discount or premium to Morningstar’s fair value estimate. Five-star stocks sell for the biggest risk-adjusted discount to their fair values, whereas 1-star stocks trade at premiums to their intrinsic worth.
  3. Whether a company has an economic moat, which will help sustain future earnings and fend off competition. 

“If businesses don't have a competitive advantage, that means they are susceptible to competition or the vagaries of the market cycle. Their earnings are much more likely to go away without a moat,” Hodge says.  

A company whose competitive advantages Morningstar expects to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with either no advantage or one that we think will quickly dissipate has no moat.

Hodge adds that at current levels, the share market is not cheap. “It's definitely not like March 2020 when there were lots of companies with a four- or five-star rating. The overall share market is still overpriced. We've gone from being quite a bit overvalued to a situation where the market is a little bit over valued,” he says.

According to HLB Mann Judd wealth management partner, Jonathan Philpot, it is important to have a very good understanding of any company before investing. 

“Know the market that it operates in, how big its market is and how competitive it is and understand how it has grown in the past and how this may look in the future,” he says. 

“This can be very difficult to judge if unable to access research, but knowing a few stocks very well, and having an understanding of the value of the share, is a better approach than following too many stocks and not really having a great understanding of any. 

“It means that when market corrections occur and the share price falls, but the business itself has not changed in any way, investors can have more confidence that it is a good time to be purchasing these good quality companies."

Stay the course

Once you’re in, stick to your guns. According to Sarah Newcomb, director of behavioural science at Morningstar, as markets drop, investors need to fight off the urge to sell their shares and crystallise losses. When the March 2020 coronavirus sell-off rattled stock markets, Newcomb said to herself, “This is the ride. Scream if you have to, but you chose to be here. You’re going to feel like such a rock star when it’s over.”

Newcomb says ‘Fear’ sells while ‘Excitement’ buys. “So, rather than trying to turn off your emotions, you can focus on trying to channel that agitation into excitement about the buying opportunities down markets can bring,” she says.

“In down markets, you can put your nervous energy into searching for assets that are selling at a discount relative to their fair market value. Understanding the difference between fundamental value estimates and market prices is essential to finding those quality companies that might be temporarily undervalued because of general market skittishness.”

Newcomb also recommends getting financial advice. “A solid long-term plan for your finances is very important,” she says. “A professional opinion on how to organise your resources to reach your long-term goals can be a very powerful exercise, as well as a source of peace and security in the midst of volatility. If you keep your eyes on the horizon, the bumps in the road are easier to stomach.”