Financial markets are inherently unpredictable, particularly in the short term. Market sell-offs, characterised by widespread panic and a rush to liquidate risky assets in favour of safe havens, occur from time to time. This is precisely what happened earlier this August when a combination of factors led to a surge in market volatility. Key drivers included the unwinding of crowded trades in technology stocks and the Japanese Yen, along with a soft patch of economic data, which heightened concerns about a potential recession in the US.
Periods of volatility, though unsettling, offer opportunities for investors. By understanding how risky assets like stocks and corporate bonds behave during downturns, investors can capitalise on discounted prices and favourable yield spreads to potentially enhance their long-term portfolio returns. This article explores how selectively buying stocks and bonds during a sell-off can be a profitable strategy, delving into the psychology of investing, historical performance, and the importance of identifying potential recovery catalysts, all the while maintaining a long-term perspective.
David Lanzon, CFA, Senior Portfolio Manager at ReAPS Asset Management Limited, a subsidiary of APS Bank.Understanding market sell-offs
Market sell-offs occur when there is a rapid, significant decline in the prices of risky assets, often triggered by economic uncertainty, geopolitical tensions, or unexpected shifts in monetary policy. During these periods, investor sentiment sours rapidly, resulting in widespread and often indiscriminate selling in equity markets. Concurrently, the bond market reacts, with credit spreads widening as investors demand higher yields to compensate for the perceived credit risk, and yields on ultra-safe government bonds fall as capital flows into low-risk assets.
The psychology of investing: Leveraging market fears for strategic advantage
Fear is a powerful driver in financial markets, often leading investors to make suboptimal decisions that can jeopardise their long-term returns. During a market sell-off, fear manifests in the mass selling of both stocks and corporate bonds, pushing risk premia higher. This often results in irrational behaviour and negative overreactions in the market. However, experienced investors recognise that fear can also create opportunities.
By staying calm and recognising that market sell-offs are temporary – where often “good” assets sell-off alongside the “bad” — investors can take advantage of lower stock prices and wider credit spreads. Warren Buffett’s famous adage, “Be fearful when others are greedy, and be greedy when others are fearful”, applies not only to stocks but also to bonds. When others are fleeing the market, investors can seize the opportunity to buy good-quality assets at discounted prices. For instance, in early August, the shares of a leading global automaker were trading 24% lower when compared to their end-of-July market valuation. During the sell-off, the same stock was at one point priced at a 20% discount to the company’s recently announced buyback price. While there may have been rational reasons for this sharp decline in price, wise investors would thoroughly investigate the price dynamic, as the potential to profit from an overreaction can be substantial and tends to be short-lived.
The historical perspective
History demonstrates that market sell-offs, though painful in the short term, are often followed by periods of recovery and growth. The 2008 financial crisis is a prime example. By mid-2009 the S&P 500 index had dropped nearly 57% from its previous all-time-high. However, those who invested in stocks during the downturn saw significant gains as markets recovered.
More recently, investment-grade corporate bonds purchased during the 2020 market sell-off provided attractive yields relative to their risk. In March of that year, credit spreads surged as investors feared a severe economic impact from COVID-19 lockdowns. In the months that followed, credit spreads tightened back to their pre-pandemic levels as monetary and fiscal programmes were implemented to support economies. Additionally, global progress in treatment and precautionary measures against the virus also contributed to the recovery.
While market indices suffer from survivorship bias, as stocks and bonds issued by unsuccessful companies are replaced by those of more successful ones, the historical pattern still underscores the importance of maintaining a long-term perspective. Good-quality stocks and corporate bonds tend to recover as markets stabilise.
Buy low, sell high
It should now be evident that the principle of “buying low and selling high” is especially relevant during market sell-offs. For stocks, this means purchasing shares of good-quality companies at prices well below their intrinsic value. For corporate bonds, it involves buying bonds of companies with good credit fundamentals when credit spreads are wide, capturing higher yields that will benefit from price appreciation as spreads narrow.
Additionally, savvy investors seek to identify one or more catalysts that could drive a market recovery. Take this summer’s sell-off as an example: Will the market recover because investors will realise that recession fears are unfounded? Will a recession occur, causing the market to dip further before recovering? Will central banks expedite the process of easing monetary policy? Forming an educated opinion on such questions can help investors select the right assets to maximise their gains during the recovery period.
Long-term perspective and avoiding the temptation to time the market
Maintaining a long-term perspective is crucial when navigating a market sell-off. Short-term market fluctuations can be unsettling, but the return potential of well-chosen stocks and corporate bonds can be significant over time. Investors who remain focused on their long-term goals are better positioned to weather the volatility and emerge with stronger portfolios.
One of the most common mistakes investors make during a sell-off is attempting to time the market—waiting for the perfect moment to buy at the lowest point. This approach is particularly challenging, as predicting the market’s bottom is nearly impossible. Rather than attempting to time the market, investors should focus on the quality and type of assets they are purchasing and their long-term return potential.
By maintaining a long-term view, investors can avoid the pitfalls of short-term thinking, such as panic selling or attempting to time the market. Instead, they can focus on building a diversified portfolio, taking advantage of the opportunities that arise during periods of market stress.
Turning turbulence into triumph
While market sell-offs can be unsettling, they offer valuable opportunities for investors to acquire assets at attractive prices. This does not mean that low-risk assets like government bonds do not have a place in investors’ portfolios. On the contrary, safe-haven assets are powerful portfolio diversifiers that cushion portfolios during risk-off periods. Successfully navigating financial markets during times of turbulence necessitates skill and experience. Ultimately, those who remain disciplined — making tactical adjustments while staying committed to their investment process during market downturns — are more likely to achieve long-term financial success.
The information contained in this article represents the opinion of the contributor and is solely provided for information purposes. It is not to be interpreted as investment advice, or to be used or considered as an offer, or a solicitation to sell / buy or subscribe for any financial instruments nor to constitute any advice or recommendation with respect to such financial instruments. This article was issued by ReAPS Asset Management Limited, a subsidiary of APS Bank plc. ReAPS Asset Management Limited (C77747) with registered address at APS Centre, Tower Street, Birkirkara BKR 4012 is regulated by the Malta Financial Services Authority as a UCITS Management Company and to carry out Investment Services activities under the Investment Services Act 1994 and is registered as an Investment Manager under the Retirement Pensions Act.