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Stock market, stormy weather on the way from overseas? This is a good time to remember a few basic rules for prudent investing

11 February 2022

A big chill hit the American stock markets in January. The S&P 500, the index of the largest American companies, closed out the month down by 5.3 per cent, its worst performance since March 2020. The NASDAQ Composite Index, representative of the tech sector, fell by 9.0 per cent in January. We have to go all the way back to January 2008, when the global financial crisis began, to find a worse January for this index.

The world's major stock markets often move in the same direction. In technical terms, we say that the correlation among the indices is high. Therefore, Italy's main index, the FTSE MIB, was also affected, but its drop settled at 1.9%.

Over the three years leading up to January, the stock market had grown enormously. The NASDAQ Composite Index had more than doubled, but even back in 2021 there were signs of shifting winds. The equity prices of many of the youngest and as-of-yet unprofitable tech companies had already begun to fall.

What are the stock indices?

A stock index is an indicator of the trend of a certain group of shares, typically in a specific sector (for instance, the tech industry) or in a specific country (for instance, the USA). The index moves upwards or downwards reflecting the prices of the shares of which it's composed. The trend of the largest indices, by number and value of the underlying shares, offers a snapshot of the general stock market trend.

Instead of investing directly in one or more shares, you can invest in the shares which compose an index by subscribing to a mutual fund or by buying an Exchange Traded Fund (ETF). Basically, these financial instruments allow you to invest through one vehicle in all or many of the shares which compose the index, even with just a little money. They allow you to diversify your investments in shares and, as a consequence, to reduce the risk that you will lose the money you've invested.

The most-followed indices around the world are the United States' two main ones: the Standard and Poor's (S&P) 500, the index of the 500 biggest American companies, and the NASDAQ Composite (National Association of Securities Dealers Automated Quotations), consisting of more than 3,500 different kinds of shares, for the most part tech companies.
The main Italian index is the FTSE MIB (Financial Times Stock Exchange Milano Indice di Borsa), composed of around 40 different stocks representing the main Italian listed companies.

When discussing the reasons for the decline in the American stock market, the specialized press pointed to lowered expectations for US economic growth rate, risks that the Federal Reserve (Fed), the US central bank, would hike rates in order to fight inflation, and high company valuations after the growth of the last few years.

It is difficult for us to know what the future holds. It is even more difficult to predict the stock market's trend and, in particular, when a period of rising share prices ends and one of falling prices begins. Even professional investors often fail at this task. Trying to anticipate when the stock market is going to turn in order to buy during the troughs (lowest prices) and sell during the peaks (highest prices) is one of the less common investment strategies but is also among the most costly if you guess wrong.

Shares are risky. Therefore, they are only the right investment for you if you can afford to take a loss and if you are able to hold them for the long term. It is important that you do not need to sell your shares in the short term. Over the long term (for instance, 10-20 years), the market’s ups and downs balance one another out and shares usually provide a higher return than do less risky instruments (such as deposits and government bonds).

Finally, remember that the best investment strategy is to diversify. By doing this, you can reduce the risk of loss. In the case of shares, diversifying means that you should not invest in one or just a handful of companies, but rather you should buy shares of many different companies. Therefore, the losses on one share can be offset by gains on another. Investing in several indexes tied to the stock markets of different countries is also a way to diversify and reduce risk even more. Putting all your eggs in one basket is always very risky!