Talk about dramatic. Facebook’s share price had such a giant fall this week, it was worth like $300 billion less on Friday afternoon than it was on Friday morning.

While it grabbed a lot of headlines, it was just the icing on a cake that has been cooking for weeks now, both in Australia and the US.

A friend of mine sent me a message that said, “I know you’re right about not selling shares. But the last few days are testing me, for sure.”

And sure, nobody likes to the see the value of their investments go down. However, that’s kinda what you sign up for when you invest in equities.

Why are markets having a moment?

A key factor behind the drama is inflation, or the prices of things going up.

It’s high – surprisingly so – in markets like the US and Australia. Central banks (the Fed and the RBA) are very picky about inflation – they want a little bit, but not too much. In Australia, the RBA has a target of 2-3% inflation, because it means the economy is growing but not going crazy.

We all know prices have been going up – buying petrol physically hurts me. So, when the inflation figures for Australia came out last week at 3.5%, it caused a bit of a ruckus. For a long time there it was stuck at around 1.5%.

And if you think that’s bad, the US is battling inflation figures above 6%. In this situation, the central banks have one big lever they can pull to bring inflation down: raise interest rates.

Inflation is a sign of economies being overheated – it’s like the tail end of a children’s birthday party where excited 5 year olds are careening around fuelled on red cordial. Except, the cordial is cheap money borrowed at low interest rates.

Into the fray come parents with time-out corners and half an hour of watching Bluey. They need to cool things down, and for central banks, higher interest rates are like the ABC Kids channel. When money costs more to borrow, economic activity like buying houses or growing businesses becomes less attractive.

Thus, when inflation is going up, markets get worried that the cheap-money-economic-growth tap is about to be turned off. The stocks that are sold off most ruthlessly tend to be the ‘growth’ style companies: those with big ambitions and cool business models but – quite often – not a lot of cash or even profits. I’m looking at you, tech stocks.

Growth vs Value

These growth-style stocks have been going gangbusters for the last year or more, so the fall in value seems even more dramatic. If you’re invested in a tech-heavy fund like Spaceship Voyager, you’ll be feeling the pain more than investors with a more balanced portfolio. However, you’ve also had higher returns than some of those investors, so it may just balance out in the end.

And remember – higher returns mean higher risk. Many growth stocks are based on future visions of success but little in the way of actual profit. The opposite of growth investing is value investing, and the father of value investing, Benjamin Graham, speaks dubiously about “exciting adventures into the glamorous and dangerous fields of anticipated growth”. But then, value investments have lagged behind their growth counterparts for over a decade, so who knows?

This is an oversimplification of course. There are many factors at play in the markets at any given time. What we do know is that selling out when things get tough is generally not a great idea. If you sell when the value of your portfolio drops, it means any losses that are theoretical become actual losses.

Unless you have a specific and urgent need for the money at that time, it makes sense to hang on and wait until the market recovers.

The problem with ‘picking the bottom’

For the more pessimistic amongst us, the current market correction is unsurprising. There are so many companies with lofty valuations (i.e. share prices) that seem detached from reality. When this happens, it rings alarm bells for a lot of investors.

‘Valuations are stretched’, they say. ‘Price/earning ratios are high’, meaning the price of a stock is out of sync with the earnings the company is generating. A lot of market gurus look at the current situation and think ‘something’s gotta give’.

And when prices fall, they plan to pick up some bargains. A lot of people did that back in April 2020, when COVID crashed the market. After equity prices fell up to 30%, the bargain hunters rushed in like it was the Boxing Day sales, leading to a fast recovery that many investors have benefited from.

The trick with falling markets is picking the time when they have fallen as far as they’re gonna go, and buying at that moment. ‘Picking the bottom’ is a great idea, but bloody hard to do in reality.

It’s like when you go to the Cue sale and it’s 30% off the dress you want, and you have to guess if it will go to 50% off next week. And if you wait too long, they run out of your size anyway.

In market terms, if you go too early, you buy shares that fall further. If you wait too long, the rally starts and prices go up, leaving you to miss out on the bargains. This is why a lot of people caution against ‘timing the market’. The alternative is regular investing of smaller amounts, known as ‘dollar cost averaging’, so that you get a bit of both the ups and downs, and it all works out in the wash.

So, in summary. If you are already invested, you might just want to hang in there and do nothing. If you are thinking of buying more shares, you may pick up some bargains now, or in a month or two – who knows? Otherwise, making regular purchases can be a sensible option. And if you are keen to start investing right now, you probably have an appetite for risk and nerves of steel – in which case, I salute you!