The economics of the stock market is simple really: buy and hold

Economic View: But the key here is not to sell with the herd when markets drop sharply, as they did last week, but to ride it out

Trillions get “wiped off” stock markets. But they never seem to get “wiped on”. That’s not true, of course. Stocks markets surge just as often as they plummet. It’s just that the surges tend not to get so widely reported.

Stock market collapses, like those seen across the world at the start of last week, lead nightly television news bulletins and get splashed across newspaper front pages. They’re big news. Stock market recoveries, like those towards the end of the week, tend to receive less publicity. It’s human nature. “End of the world” is an engaging headline. “Not the end of the world” isn’t.

Does any of it ultimately matter in economic terms? Many would argue that the answer is no. A now ancient joke among economists is that stock markets have predicted 10 of the past five recessions.

Many people are under the impression that the Wall Street Crash (when shares fell 24 per cent in two days in October 1929) led inexorably to the Great Recession of the 1930s. It didn’t. What caused that colossal economic slump, when GDP fell by 25 per cent, was the failure of thousands of American banks and the abject failure of the US authorities to ensure there was enough money circulating in the economy. In Europe the slump was primarily the fault of the old Gold Standard, that ludicrous monetary system (which some libertarian wingnuts want to resurrect) that compelled governments to hike the cost of borrowing in order to prevent gold outflows at the worst possible time for their domestic economies.

Economies can ride out share crashes. On Black Monday in October 1987 US stock markets sank by 22 per cent in a single day – a sell-off as severe as the Wall Street Crash. Yet there wasn’t even a recession, never mind a depression. Within two years the US stock market was back to its previous peak.

However, equity market swings can have real economic effects to the extent that they scare policymakers into “doing something”. That’s certainly true in China, where the People’s Bank of China cut interest rates last week after its stock market shed 15 per cent in two days. It may prove to be true in the West too. Many financial traders think the US central bank, the Federal Reserve, will now push back the date of its first hike since the financial crisis to next year. It had previously been expected this month. Market expectations of the date of the first rate hike by our own Bank of England have also been pushed back further into next year.

That may well be sensible given how little evidence there is of a resurgence of inflation. Nevertheless, this kind of stock market-induced policymaking is problematic. Traders used to talk about a “Greenspan put”. This was named after the former chair of the Federal Reserve, Alan Greenspan, and referred to the belief that the Fed could be relied upon to cut interest rates if the stock market suffered a deep sell-off. This is certainly what seemed to have happened in the wake of the dotcom bubble burst in 2000, when many over-hyped technology companies saw their value wiped out. The Nasdaq stock exchange fell 77 per cent and Greenspan’s Fed took interest rates down from 6.5 per cent to 1.75 per cent in the space of just 12 months. It’s not healthy if investors can count on being bailed out by cheap liquidity if markets slump.

Monetary policymakers really shouldn’t react in this way to stock market gyrations. And in public they’d deny that they do. They’d talk about more generalised concerns about “confidence” and potential “spillovers”. But the truth is that big stock market movements have a mesmerising power which induces a kind of panic response, even among sober central bankers.

For the rest of us the thing to remember is that in the long term it pays to buy and hold shares. Financial economists have long grappled with the so-called “equity premium puzzle”. This refers to the fact that based on the stream of dividends that company shares will likely return to investors they are undervalued relative to other financial assets like government debt and corporate bonds. That’s even allowing for the fact that people need to be compensated for the additional risk involved in holding shares, as opposed to fixed interest bonds. The puzzle is evidence against the hypothesis that financial markets are always “efficient”. But that’s a different column. The point here is that by buying shares a typical investor can profit from the market’s chronic undervaluation of equities as an asset class.

Of course individual shares can be highly risky. Listed companies go bust, wiping out shareholders. But the antidote to this risk is to have a diversified portfolio of shares, spanning different sectors and markets. Most ordinary investors would do better buying into funds that track a broad index like the FTSE All Share rather than taking stock tips on individual companies. Earlier this week virtually all shares sank, turning traders’ screens into an ocean of red. But this is rare. In normal times shares do not tend to rise and fall in synchronisation. For every company that loses value, another will put it on. And the winners will normally outnumber the losers over a sufficiently long period.

Volatility, which puts many people off stock markets, is certainly a potential problem. But the key here is not to sell with the herd when markets drop sharply, as they did last week, but to ride it out. Diversification can help here too. Investors can buy tracker funds for American, Asian, Continental European and Latin American stock markets. The rise of user-friendly and inexpensive online investment platforms makes this a relatively simple process nowadays. Just as individual shares will not generally move up and down together, indexes in different countries will not be correlated.

The stock market has a reputation for being a rigged casino. In countries such as China, where the state does try to manipulate outcomes, that’s got a large element of truth. But by and large the stock markets in the developed world – despite all the lurid “trillions wiped off” headlines – have been more like a cash machine for the patient, long-term and sensible investor.