Stock Market Misconception – Going Down vs Gone Down

by Guest Contributor · 15 comments

There’s one question that I’ve seen asked more times than any other over the last several months: “Should I keep investing in the market given how much it’s going down right now?”

To me, this question suggests a fundamental misunderstanding. The market isn’t “going down.” A more precise way to explain the situation is to say that the market “has gone down.”

Given that most of us don’t spend time on the trading floor of the NYSE or watching minute-by-minute price changes online, we don’t really know what the market is doing right now. In reality, all we know is what has already occurred. That is, we can only see the past.

What’s the big deal?

It might sound like a minor distinction, but I’d argue that it leads to some noteworthy mistakes. Most importantly, when we say that the market “is going down” we imply that it’s going to continue to do so. However, the fact that the market has just gone down isn’t in itself a good reason to think it will go down more.

Does the Market Move with Momentum?

Some investors would say that I’m completely wrong. They argue that the market has momentum when it moves. That is, they believe that if the market has just gone down, it’s more likely that the market will continue to move downward over the following period.

The bulk of academic studies, however, indicate that this isn’t the case. In fact, there’s almost zero correlation between market movements from one period to the next. (That is, what the market did in the prior period is not a very helpful indicator in predicting what it will do during this period.)

So How Does This Affect You?

If, for some reason, you’re convinced that the market is about to move downward (or upward), fine. But please don’t think that it’s going to do so simply because that’s what it’s been doing lately. If it were that easy to predict, why would investors have such a poor track record with timing the market?

As you’ve probably already guessed, my suggestion is just to stick with a passive investing strategy that’s not dependent upon trying to predict what the market is going to do next.

About the Author: Mike writes at The Oblivious Investor where he reminds readers to ignore the day to day noise in the market. If you like this post, please subscribe to his blog for free daily updates.

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{ read the comments below or add one }

  • Aaron: You’re right. That particular paper only applies to individual stock prices.

    Also, any other studies I recall reading tend to analyze the existence (or lack thereof) of momentum over periods of greater than one day. For example, they show that there is little correlation of market movements from month to month or year to year.

    You may be correct that there is momentum from today to tomorrow.

  • Aaron says:

    Admittedly, I didn’t read through the entire paper, but it seems to apply to individual common stocks. Does it also apply to market movements as a whole?

  • Aaron: The most famous research that I’ve encountered regarding the topic was by Eugene Fama. You can find it here:
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=321524

    Since then several studies have been done (just do a few searches on SSRN) that confirm the same thing.

  • Aaron says:

    Is there really no correlation between market movements day to day? I’d imagine then since so much of market movement is behavioral, that a pack mentality would set in. As you said, the fact that most people get their data on a delayed basis would indicate that their reaction is also delayed. Hence when they see major sell-offs, they want to join the selling frenzy. Of course they could also respond in a contrarian manner and buy. Either way, I’d be reluctant to say that market movements are not affected by the previous day. I would admit that they are unpredictable based on prior day’s trading though.

  • Ryan @ SpendOnLife says:

    I think your age plays a role in this as well. I don’t know whether or not the market is going up or down in the next months, but I am pretty confident it will by higher than it is now at several times in the next 15 years. So if you are under 40 buying into the market now seems like a reasonable risk.

  • TStrump, he plans to cash in all of his stocks once he retires?

    What you bring up is a fascinating topic, though. It’s been discussed in several places over the last decade. It’s true, GenX and GenY don’t have the financial resources to buy all the stocks that the Baby Boomers will be liquidating unless they do so at reduced prices.

    What does appear to be happening, however, is that demand from international buyers has been increasing sharply. In other words, investors in India and China are buying growing portions of our stock market. (Up to you whether that’s in fact a good thing.) Jeremy Siegel’s The Future for Investors has a very thorough discussion of this topic. It’s pretty fascinating.

  • TStrump says:

    I agree, it’s difficult to time the market.
    With passive investing, I definitely plan on investing in some index funds for the long term. I’m just not that good a stock picker … yet.
    I believe the market will rebound very soon and will rally into next year, but I also feel there will be a final crash or adjustment by 2010 as boomers begin to retire.
    Why? I have a friend who is 62 and is retiring soon. He plans on cashing in his stocks by late next year. What if every Boomer does this?

  • Chiko777 says:

    The stock market has already gone down and has starting making it’s move upward (since March). I have been buying and accumulating share since then. We are out of the reccession, most people don’t know that but will soon find out come July.

    People are always late to the seen…that’s why they always wonder why they can’t seem to predict where the market is going.

  • MoneyEnergy says:

    I like the distinction you make between what the market *just did* vs. “what it’s doing now.” You’re right, we’re not on the trading floor (though some of us have real-time electronic trade desks, right?), so we usually only have 15-minute delayed quotes. I don’t know enough about the theories behind market “momentum” to argue one way or the other. But I just buy based on current needs and what I know about the fundamentals. Well, I also *try* to buy on dips.

  • i s rao bhopal says:

    I read the article. It is forthright, and convincing too. I wish to have his comment on the following:-
    1. Market discounts the news before the majority even come to know.
    2. it is being talked that just when elections get completed or around this time, market will dip by 1000-2000 points.
    3. Technical charts with help of Moving averages, do predict the trend on past period behaviour. I am sure, it is scientific too.

  • UH2L says:

    To add to your post MoneyNing, if the prior period is an indicator of what’s going to happen in this period, then the stock market would have gone up forever or down forever. There has to be long term inflection points or we would never have bull or bear markets.

    As for how one invests, it’s not about knowing more; it’s about following a systematic approach to investing and taking the momentum, emotion, and news out of the equation. It’s easier said than done though as I succumbed a little bit to the massive downward moves late last year, sold some stock funds for bond funds when I probably shouldn’t have. Luckily, I’m back on track.

  • Jason Unger says:

    This is a great post. Most of the time, by the time a trend is identified, it’s already too late to make your changes.

    The market is down. It’s too late to cash out.

    Make changes on your own timetable, and not in response to what the market is or isn’t doing.

  • Weakonomist, that’s basically the story of my life. I think almost everybody has thoughts about what the market will do next, or what company would likely make a great investment right now, etc.

    The trick is realizing who the competition is, and remembering that it’s exceedingly unlikely that we know more than they do.

  • I have my own ideas on what the market will do next but I’d never put my money where my mouth is.

    • MoneyNing says:

      My first reaction was “what? why not?” but after thinking about it for a section, I realize that it’s probably the best thing to do. Like Mike (author) always say, ignore the noise and keep investing through the thick and thin.

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