Canadian stock market roller coaster

What Is Happening to the Canadian Stock Market and How Does It Affect You?

Last updated on February 19, 2018 Views: 13371 Comments: 0

The Canadian stock market has been on a roller coaster ride to start 2018, with sharp inclines followed by gut-wrenching drops. The ride has not been for the faint of heart or head, prompting many an investor to scream demands of “let me off! Stat!”

While our first reaction to a plummeting market might be to unbuckle, jump off the ride, and sell our investments at a loss, that’s the exact opposite of what we should do in these cases. I reached out to a Canadian financial firm in an attempt to calm your nerves (and maybe mine too) with an eye-level explanation of what’s happening to the Canadian stock market.

What Triggered This?

Two major economic/financial events may have started this stock market roller coaster—one domestic and one cross-border.

Interest Rate Hikes

After standing pat or lowering interest rates for about seven years, the Bank of Canada showed new confidence in the growing Canadian economy by increasing interest rates three times in the last six months. Is there a link between these actions and the market drop?

“There is. Interest rates rise when inflation is increasing. Increased inflation happens as the economy grows and corporate profits rise. But rising rates tend to cool things off, because it costs more to service debt,” says Jason Heath, CFP, Managing Director at Objective Financial Partners Inc.

And Canada has no shortage of debt to be serviced.

“The Canadian economy is really susceptible to rising rates given how much debt we’ve accumulated in recent years,” says Heath.

So much debt, in fact, that Canadian investors may have rushed to sell their stocks after the most recent interest rate hike, lowering the stocks’ value. Will this reaction influence the Bank of Canada’s decision-making process for possible interest rate hikes later this year? Not likely. The Bank of Canada isn’t as concerned with short-term market drops as it is with developments that could affect the Canadian economy for years to come.

Possible NAFTA Renegotiations

NAFTA, short for the North American Free Trade Agreement, is the world’s largest free trade agreement signed between Canada, Mexico and the United States. The looming possibility of a U.S. withdrawal from NAFTA, or more likely, renegotiations, could spell trouble for the Canadian economy and stock market. If the U.S. starts slapping tariffs on major Canadian industries—like softwood lumber and energy—it would adversely affect the Canadian economy since these industries depend on free trade with the U.S. To say that our two economies are interconnected would be a vast understatement.

“About 16% of U.S. exports go to Canada. 35 states list Canada as their top export market. As for Canada, the U.S. buys about 57% of our exports. 39% of our imports come from the U.S. The implications of NAFTA negotiations could be significant and Bank of Canada Governor Stephen Poloz recently said it’s one of the things that keeps him up at night,” explains Heath.

The reduced interest rates combined with fears of NAFTA renegotiations may very well have been a 1-2 punch that made Canadian investors seriously skittish. But we shouldn’t be.

Investor Psychology During a Stock Market Drop

When stock markets fall, investors of all income and experience levels go into a panic. We’re often told to “buy low, sell high,” but many Canadians temporarily lose their even-tempered manner and do the exact opposite. We read the news headlines, overreact and sell our investments for a huge loss, which is the worst thing we can do in this scenario.

“Buying low and selling high is the ideal investor behaviour. But many seem to sell in panic (sell low) and buy in euphoria (buy high). Warren Buffett once said ‘the stock market is a device for transferring wealth from the impatient to the patient.’ I think this is why you’ll see volatility in the near-term as undisciplined investors react and opportunistic ones respond,” says Heath.

A large number of investors “selling low” leads to further market volatility. Similar to home prices, stock market prices are based on the basic laws of demand and supply. When demand wanes from investors panicking and supply increases from investors selling, it leads to a lower stock market price. This lower stock market price can cause investors to panic even more and continue to sell, diminishing the price further.

How Can Canadians Avoid Further Financial Loss in an Erratic Stock Market?

Now that you have a little context for what causes these market drops, how can you protect your investments in the (likely) event of ongoing volatility?

Reconsider Your Risk Tolerance

While your gut reaction may be to “sell, sell, sell” during a stock market downturn, that’s the kind of widespread attitude that causes stocks to drop precipitously. There are better ways to keep calm on the coaster.

“The best way is to be invested in a portfolio that is suitable to your risk tolerance in the first place. You shouldn’t take on any more risk than you can handle and some would say you shouldn’t take on more risk than you need to in order to achieve your goals,” says Heath.

You can find out how much risk you’re comfortable taking on by completing a customer investor profile questionnaire with your bank or brokerage. This is typically completed before investing your money. This questionnaire asks you questions about your time horizon and investment volatility, so you’re less likely to invest in something with more risk than you can stomach.

“If these declines have got you rattled, you should reconsider what your true risk tolerance is and make sure your current investments line up to that risk level,” Heath added.

Investing Based on Your Time Horizon

If you’re invested for the long-term, you shouldn’t be too concerned about day to day fluctuations in the stock market.

“I would try to ignore the headlines, as they can be a little sensationalized. A globally shouldn’t likely lose money over a 5-year period. So if your money is invested for the long term, don’t react to short term fluctuations,” says Heath.

And if you may need the money you’re investing for living expenses, you probably shouldn’t be investing it in the stock market to begin with.

“If it’s needed in the short term, you shouldn’t have much exposure to stocks in the first place,” says Heath.

The Benefit of an Investment Policy Statement

To avoid emotion-driven reactions and incurring heavy losses during a stock market drop, it helps to have an (IPS). Many advisors use formal investment policy statements, but even DIY investors should consider a similar type of framework. A DIY IPS would be a written contract that you’d make with yourself. By putting your DIY IPS in writing, it helps hold you accountable to yourself, making it less likely that you’d make a trade in a panic that contravenes your IPS.

Consider Robo Advisors to Take the Emotion Out of Investing

Robo advisors are a relatively new investing development that can mitigate the chance of human mood swings affecting your investments. Robos when stocks rise or fall, reinforcing that optimal “buy low, sell high” behaviour. Are they the solution to the emotion-driven market fluctuations we’ve been seeing? They can be, when you understand them properly. But not everyone is comfortable entrusting their investments to a non-human entity.

“One problem I think exists with robo-advisors is there may not be the right amount of hand-holding some investors need to stay invested when the going gets tough. And that reinforces that robo-advisors aren’t for everyone. No solution is for everyone,” says Heath.

When Will This Ride Be Over?

Though my crystal ball is currently at the cleaners, I’ll go along with most analysts and agree that stocks are likely to continue this volatile course in the short-term.

“Now that we have seen big declines, that could lead to further panic selling or it could lead to aggressive buying by opportunistic investors. Day to day movements in the stock market are hard to predict, though the financial industry and media spend a lot of time trying. Over the long run, stocks will go up. In the short run, it’s anyone’s guess,” says Heath.

Remember, the way we investors react to a fluctuating economy and market can either balance the fluctuation out or make it even more dramatic. So if the roller coaster turns out to be a trifle more wild than you bargained for, may I advise you to ride it out instead of popping off the metal restraint and jumping into oblivion?

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