Why Do Stock Markets Fall?

Seeing the value of your investments fall is uncomfortable.

A pension or investment that was worth £100,000 might suddenly be worth £90,000. Open the news and you’ll probably find plenty of explanations for why: inflation, interest rates, war, company results or fears about the economy.

Sometimes several at once.

If you read my earlier blog, What Is the Stock Market?, you’ll know that when you invest in shares, you own small pieces of real businesses.

So why can the market suddenly put a lower price on thousands of perfectly real businesses?

To understand that, we need to look at what a share price actually represents.

The Stock Market Is Always Looking Forwards

A share price isn’t simply a measure of how a company is performing today.

It also reflects what investors think that company might achieve in the future.

Imagine two companies each made £100 million profit last year.

Investors expect the first company’s profits to grow significantly over the next decade. They expect the second company’s profits to remain roughly where they are.

Investors are unlikely to be willing to pay the same price for both businesses.

Investors may be willing to pay more for the first company because they expect its future profits to be greater.

The important word is expect.

Nobody knows exactly what either company will earn next year, let alone ten years from now.

Investors are continually making judgements about an uncertain future and deciding what they think those future profits are worth today.

When those expectations change, share prices change.

Prices Change When Expectations Change

Imagine investors expect a company to make £1 billion profit next year.

Then something changes.

Perhaps its costs have risen. Maybe demand for its products is slowing. A competitor has launched something better. Interest rates have increased. The economy looks weaker than previously expected.

Investors now think the company might make £800 million rather than £1 billion.

The business hasn’t disappeared.

Its factories may still be running. Its employees are still going to work. Customers are still buying its products. It might still be making hundreds of millions of pounds in profit.

What has changed is investors’ view of its future and the price they’re prepared to pay to own part of it.

So its share price falls.

Why Can Good News Make a Share Price Fall?

This is where markets can appear particularly confusing.

Imagine a company announces that its profits have increased by 10%.

That sounds like good news.

Yet its share price falls.

Why?

Perhaps investors expected profits to increase by 20%.

The company performed well, just not as well as the market had already expected.

The reverse can happen too.

A company can announce falling profits and see its share price rise if investors had expected the results to be even worse.

Markets don’t simply respond to whether something is good or bad.

They respond to what actually happened compared with what investors expected to happen.

This helps explain why predicting short-term market movements is so difficult. You don’t just need to know what will happen next. You would also need to know what millions of other investors already expect to happen.

Why Do Whole Stock Markets Fall?

So far, we’ve been talking about individual companies.

The same principle applies to entire markets.

Some new information only affects one business or industry. Other developments can change expectations for thousands of companies at once.

A recession, for example, could mean people and businesses spend less money. Investors may therefore expect profits across many companies to fall.

Higher inflation can increase costs and reduce what consumers can afford to spend.

Events or conflicts can create uncertainty about trade, energy prices or the wider economy.

Interest rates can also have a wide effect.

Higher rates can make borrowing more expensive for businesses and consumers. They can also make other investments more attractive. If investors have the potential to receive more attractive returns from other investments, they may be less willing to pay a high price today for the uncertain future profits of a company.

None of these factors needs to affect every company in exactly the same way. They can, however, change expectations across enough businesses for an entire stock market to fall.

Selling Can Make Falls Bigger

Changing expectations can cause prices to fall. What happens next can sometimes make those falls larger.

Imagine worrying news arrives and lots of investors decide they want to sell.

At yesterday’s price, there may not be enough buyers.

Sellers therefore have to accept a lower price to find someone willing to buy. If uncertainty increases further, buyers may demand an even lower price.

Some investors may then become more worried precisely because prices are falling and decide to sell too.

Not everybody selling has panicked though. Investment funds may need cash because investors are withdrawing money. Other investors can sometimes be forced to sell as prices fall.

This can add further selling to an already falling market.

So a falling market isn’t necessarily millions of investors independently deciding that every company has suddenly become a bad business.

There can be several things happening at once.

A Falling Price and a Failing Business Aren’t the Same Thing

This is perhaps the most useful distinction to make when looking at a falling investment portfolio.

Imagine you own a diversified investment containing shares in hundreds or thousands of businesses around the world.

The value falls by 15%.

What has actually happened?

You still own shares in those businesses.

Some of the businesses themselves may have changed very little. They may still be selling the same products, serving the same customers and making similar profits.

Others may genuinely have become less valuable because their prospects have deteriorated. Some may struggle for years. A small number may eventually fail altogether.

What has definitely changed is the price investors are currently prepared to pay to own them.

A 15% fall in the market doesn’t mean every business you own has suddenly become 15% worse at making products, serving customers or generating profits.

Price and business performance are connected, particularly over longer periods, but they aren’t the same thing.

Diversification can reduce your reliance on any single company, industry or market, but it cannot prevent losses. A diversified investment can rise but still fall significantly in value, which means you could get back less than you invested, returns aren’t guaranteed.

What Does a Market Fall Actually Tell Us?

This distinction leads to another useful question.

If the market has fallen by 15%, what do we actually know?

We know that prices are lower than they were.

We know investors, collectively, are now willing to pay less for the investments being traded.

We might also understand some of the reasons. Perhaps expectations for economic growth have weakened or interest rates have changed.

What the fall doesn’t tell us is exactly what happens next.

A falling market isn’t a forecast handed to us by the market. It is the result of millions of investors reacting to what they know, what they expect and the uncertainty they face.

That matters when financial headlines try to explain every movement.

A market fall tells us what has happened to prices.

It doesn’t remove the uncertainty about what comes next.

Market Falls Are Part of Investing

Nobody enjoys seeing their investments fall.

A 20% fall doesn’t feel like an interesting lesson in how markets process information when it’s your pension on the screen.

Yet periods of falling prices aren’t unusual interruptions to investing. They are part of what investing involves.

Owning businesses offers the possibility of participating in their future growth and profits. That opportunity comes without knowing exactly what those businesses will earn or what other investors will be prepared to pay for them in future.

Investment values can rise and fall and returns aren’t guaranteed. You could get back less than you invested.

Diversification can reduce your reliance on any single investment and a longer timeframe gives you more opportunity to ride out periods when markets are falling. Neither removes investment risk.

This is one reason the purpose and timeframe of your money matter before deciding to invest.

If you know you’ll need the money soon, a significant market fall could leave you needing to sell while prices are down rather than having the option to wait and see what happens.

Money intended for something many years away has a different timeframe. Even then, there is no guarantee about what markets will do.

Difficult Periods Don’t Mean Investing Has Stopped Working

When markets are rising, investing can appear straightforward.

Falling markets remind us what investing actually involves: owning businesses whose futures are uncertain and whose prices will change as expectations change.

None of this means every market fall should simply be ignored. Your circumstances can change. Your financial plans can change. Investments that were appropriate in the past won’t necessarily remain appropriate forever.

A market fall alone, however, isn’t evidence that the basic idea of investing has stopped working.

Anyone investing for the long term should expect difficult periods along the way.

Not because we know when they will happen.

Not because we know how far markets might fall.

Not because we know what happens afterwards.

Simply because uncertainty was there from the beginning.

Although the content of the article was correct at the time of writing, the accuracy of the information should not be relied upon, as it may have been subject to subsequent legislative or event changes.

Matthew Birkett
Chartered Financial Planner
Birkett Financial Planning