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Why falling stock prices are good for most people

Think about it.
Think about it.
Photo by Hannelore Foerster/Getty Images

Over the past 12 months, the unemployment rate has fallen, and real incomes have gone up, thanks to low commodity prices. It's not necessarily the best of times, economically speaking, but things are better than they've been in years. But much financial news has been bleak lately — generally with a focus on the stock market, which is broadly down. The S&P 500 index of major companies has lost almost 10 percent of its value over the past year, leading many middle-class workers to tremble in fear at the state of their 401(k) or IRA plans.

But the truth is most people shouldn't worry. If you're already retired or planning to retire very soon, a down stock market could be genuinely bad news for you. But if you're a decade or four from retirement, as most people are, then cheap stocks are almost certainly good for you.

So no matter how grim the stock market gets in the coming weeks or months, you should resist the urge to panic-sell your stocks. If anything, you should look at a down stock market as a buying opportunity. If you hold on to — or even expand — your stock portfolio, you'll be better off in the long run.

Stocks move faster than reality

The price of shares of individual companies moves up and down considerably in response to specific news about products, profits, personnel, and other such matters. That's as it should be. Good news about Facebook makes owning a slice of Facebook more appealing, so the price goes up. Bad news about Twitter does the reverse, so the price goes down.

But the market as a whole also goes up and down for somewhat mysterious reasons. This long-term chart of the ratio of the price of S&P 500 stocks to the earnings of S&P 500 companies makes the point pretty clearly:

There are big waves of optimism and pessimism and lots of little gyrations within those waves.

When a particular stock goes down, that's usually because something bad happened to the company. But when the market as a whole goes down, the sheer waves of optimism and pessimism are almost always playing a role. That means these swings in prices are much larger and faster than the swings in the value of the underlying assets of corporate America.

After all, while it may be true that the S&P 500 is down 10 percent over the past year, it's not as if 10 percent of the country's capital goods were destroyed in a war. It's not even the case that profits have fallen 10 percent. That's why virtually all investment advice exhorts you to save and invest for the long term rather than worrying about the daily or even monthly ups and downs.

Cheap stocks are good for savers

The upshot of all this is that if you are still working and saving and investing for a retirement that isn't going to come for decades, cheap stocks are good, because it means that whatever share of your income you are setting aside is garnering you more shares of stock.

The lower the big indexes go, the larger the slice of corporate America you get to buy, which means you'll be better off in retirement.

This logic doesn't apply to corporate executives whose compensation is linked to short-term stock prices, to old people who are looking to spend accumulated savings, or to stockbrokers who take advantage of cognitive errors to extract excess trading fees from normal people. Media coverage of financial news, unfortunately, is generally geared to those audiences and ends up emphasizing the negative.

But whether a falling or rising price of any asset is good for you depends on who you are. Falling house prices are terrible for empty nesters hoping to downsize and pocket some extra cash, but they're great for young couples looking to buy a place large enough to raise a family. Stocks are just the same. If you're young and working and saving, cheap stocks are what you want.