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Investing basics: essential investing terms for turbulent times

Michael Schramm  |  03 Apr 2020Text size  Decrease  Increase  |  
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It's perfectly natural to have some anxiety given the recent market downturn. Financial jargon can add to your jitters if you can't understand what's going on.

While you can't control the markets, you can make sense of market events by gaining a better understanding of the relevant investing terms. You might even take a step further and learn some new concepts that can help you make better decisions in these unsettling environments.

Here, we define various downmarket investing terms, ones that you might see in the news and ones that can help you make better investing decisions.

Volatility

For the last month stock markets have been highly volatile. This means stock prices have bounced up and down from one day to the next. Volatility marks how much an investment's price rises or falls. If an investment's price changes more dramatically and/or more often, it's considered more volatile.

Price volatility is usually expressed in terms of standard deviation, or how much an investment's price has fluctuated around its median price over a certain time period. A higher standard deviation implies an investment's price is more variable.

Investments with more uncertain outlooks, like stocks, are typically more volatile. That's because a stock's return is based on the business' profitability, which is difficult to predict. In uncertain market environments, like the current one, investors tend to be especially pessimistic about how businesses will perform, which can result in steep market declines. Conversely, bonds (particularly high-quality bonds) offer more-certain, fixed future payments, so they tend to be less volatile, as has been the case in current markets. 

So, why would you want a more volatile investment? Because you're likely to be rewarded with a higher return over the long haul. As Morningstar Direct editor Tom Lauricella has written, long-term stock market gains have offset shorter-term losses during market turmoil. Plus, as Morningstar chief investment officer Daniel Needham has discussed, market volatility can be an opportunity to buy stocks at a low price.

Risk

When your portfolio's value has declined amid this volatility, you might assume that you've taken on too much risk. However, Morningstar director of personal finance Christine Benz says that you shouldn't necessarily conflate volatility with risk, which she defines as the chance that you won't meet a financial goal.

For a retirement saver, one risk might be not taking on enough risk. By reducing your exposure to more volatile or "risky" assets such as stocks, you could significantly limit your portfolio's potential return over the long run. If you have decades left to invest, a lower return could prevent your dollars from multiplying at the necessary pace to reach the amount you need to retire when and how you want.

Even though a portfolio that is heavily tilted toward stocks might bounce around in volatile environments like this, your asset allocation might not be overly risky. If you're far away from retirement, you have time to ride out your portfolio's short-term losses and take advantage of longer-term gains that equity markets have experienced.

You might worry more about volatility if you need your money soon, like the next few years. If you're planning on retiring soon (within the next 10 years), Benz has some advice for handling a down market, including shifting to safer assets like bonds and cash, which aren't prone to such extreme price swings but have lower expected returns.

Bear market

A bear market is generally when a market segment declines by at least 20 per cemt, usually over two months or longer.

Bear markets often arise from negative investor sentiment because the economy is slowing or because people anticipate that it will. Indications of a slowing economy can include rising unemployment, decreased corporate profits, and low disposable income.

An entire stock market can reach bear-market territory, but it's also possible that only a specific market segment enters one. For instance, on March 11, 2020, the Dow Jones Industrial Average ended trading having declined over 20 per cent from its peak on Feb. 12, 2020. Meanwhile, the S&P 500 did not reach the threshold that indicates bear-market territory that day (though it has since).

Though this is the technical definition of "bear market," it is often used in a more general way, sometimes interchangeably with these other investing terms that describe the market or economy faring poorly:

A recession is generally when gross domestic product, a measure of economic output, declines for two consecutive quarters.

  • A pullback is a short-term price decline within a grander scheme of price increases.
  • A correction is when an asset's price falls at least 10%.
  • A market crash is a drastic market decline over a few days.
  • A depression is a long-term recession that can last multiple years.

You might also hear the term bearish. If someone has a "bearish" view, they have a pessimistic outlook for something.

Loss aversion

Even if you know that you have plenty of time to ride out short-term losses and selling your investments during this bear market is the wrong decision, you might still feel a drop in your gut when you see your portfolio's losses. You might be experiencing "loss aversion."

Loss aversion is the theory that investors feel more pain when they lose a certain amount of money than they feel pleasure when they gain an equal sum. In other words, you'd feel more discomfort from losing $1,000 than pleasure from gaining $1,000.

Morningstar head of behavioural science Steve Wendel's research has indicated how making emotional selling decisions, like selling investments in downturns, can hurt your returns, so unless you have reason to sell, keep a cool head even if you feel jitters.

Downside-capture ratio

If you are very sensitive to losses, you might sleep better at night holding a fund that tends to hold up better during downturns. An investment's downside-capture ratio, which measures how much a fund has lost when its benchmark had negative returns, is one way to identify these investments.

Downside-capture ratio is expressed as a percentage. So, if a fund's five-year downside capture is 82, it experienced just 82 per cent of the benchmark’s losses over a five-year period.

If you're shopping for a fund that protects on the downside, you'll want to see that its downside-capture ratio is at least under 100. If so, the fund has generally held up better than its benchmark.

Liquidity

Liquidity can have two meanings:

1. The ability to buy or sell securities quickly and easily without substantially affecting the asset's price. Large volume, blue-chip stocks like the banks are highly liquid securities. Shares in small companies with low volume activity are not considered liquid. High-level liquidity is considered a good feature for a security or a commodity.

2. Liquidity also refers to the ability of investors to convert securities into cash.

Tim Wong, director, fixed income strategies, at Morningstar Australia says amid the chaotic market movements since February 2020,  liquidity of fixed income securities has come under renewed scrutiny. Liquidity is also a question for superannuation funds, particularly those in unlisted assets like toll roads and airports, if Australians take up the government's early drawdown plan.

Exchange-traded funds have also become an additional layer of liquidity in fixed-income markets, stepping in where traditional bond market participants have stepped out.

A version of this article appeared on Morningstar.com. Additional reporting from Emma Rapaport, editor, Morningstar.com.au.

is a data journalist, investor education for Morningstar Inc.

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