When the stock market falls and the value of your portfolio declines, it is tempting to ask yourself or your financial advisor (if you have one): “Should I take money out of the stock market?” That’s understandable, but it’s wrong. Instead, you should ask, “What should I not do?”
The answer is simple: don’t panic. Panic selling is often people’s first reaction when stocks go down and there is a drastic drop in the value of their hard-earned funds. That is why it is important to know your tolerance for risk and how price fluctuations, called volatility, will affect your portfolio. Investors can also help mitigate market risk by hedging their portfolio through diversification, which includes holding a wide variety of investments.
- Knowing your risk tolerance will help you choose the right investments for you and avoid panicking during an economic downturn.
- Diversifying a portfolio across a variety of asset classes can mitigate some risks during market downturns.
- Experimenting with stock simulators (before investing real money) can provide insight into market volatility and your emotional response.
Why shouldn’t you panic?
Investing helps you protect your retirement, use your savings in the most efficient way, and grow your wealth with compound interest. Why, then, do 45% of Americans choose not to invest in the stock market, according to a June 2020 Gallup poll? Gallup posits that the reason is a lack of confidence in the market due to the 2008 financial crisis and the considerable volatility of the market last year.
From 2001 to 2008, an average 62% of American adults said they owned stocks, a level never reached since, according to Gallup. A stock market crash, due to a recession or an exogenous event like the COVID-19 pandemic, can put many investment principles to the test, such as risk tolerance and diversification. It is important to remember that the market is cyclical and that a fall in stocks is inevitable. But a recession is temporary. It’s wiser to think long-term, rather than panic selling when stock prices are at their lowest.
Long-term investors know that the market and the economy will eventually rebound, and investors must be positioned for the eventual rally. During the financial crisis of 2008, the market crashed and many investors sold their shares. However, the market bottomed out in March 2009 and eventually rose to its previous levels and well beyond. Panic sellers may have missed the market surge, while long-term investors who stayed in the market eventually rebounded and performed better over the years.
The same goes for investors who panicked (or not) in March 2020, when the stock market entered a bear market for the first time in 11 years amid the economic shocks of the global pandemic. The stock market has not only rebounded, it has hit all-time highs multiple times since then.
Rather than pass up the opportunity for your money to make more money, formulate a bear market strategy to protect your portfolio from different outcomes. Here are two steps you can take to make sure you don’t make mistake number one when the stock market falls.
1. Understand your tolerance for risk
Investors are likely to remember their first experience with a market downturn. Rapid falls in the price of an inexperienced investor’s portfolio are unsettling, to say the least. One way to avoid the resulting shock is to experiment with stock market simulators before actually investing. With stock market simulators, you can manage $ 100,000 of “virtual cash” and experience the common ebbs and flows of the stock market. You can then establish your identity as an investor with your own particular tolerance for risk.
Your investment time horizon will help you determine your tolerance for risk. If you are retired or of retirement age, you probably want to keep your savings and earn income in retirement. For example, retirees can invest in low-volatility stocks or buy a portfolio of bonds called a bond ladder. However, millennials could invest for long-term growth as they have many years to make up for losses due to bear markets.
Investing in the stock market at predetermined intervals, as with every paycheck, helps capitalize on an investment strategy called dollar cost averaging. Dollar cost averaging simply averages the cost of owning a particular investment by buying stocks during periods when the market is high, as well as during periods when the market is low, rather than trying to time the market. market.
2. Prepare for your losses and limit them
To invest with a clear mind, you must understand how the stock market works. This allows you to analyze unexpected dips and decide whether to sell or buy more.
Ultimately, you must be prepared for the worst and have a solid strategy to protect against your losses. Investing exclusively in stocks can cause you to lose a significant amount of money if the market crashes. To protect against losses, investors strategically make other investments to distribute their exposure and reduce their risk.
Of course, by reducing risk, you face the risk-return trade-off, in which reducing risk also reduces potential gains. Some ways to protect yourself against risk are to diversify your portfolio and seek alternative investments, such as real estate. Having a percentage of your portfolio spread across stocks, bonds, cash, and alternative assets is the core of diversification. The situation of each investor is different and the way in which they divide their portfolio depends on their tolerance for risk, time horizon, objectives, etc. A well-executed asset allocation strategy will allow you to avoid the potential pitfalls of putting all your eggs in one basket.
The bottom line
Knowing what to do when stocks are down is crucial because a market crash can be mentally and financially devastating, especially for the inexperienced investor. Panic selling when the stock market is falling can hurt your portfolio, rather than help it. There are many reasons why it is better for investors not to sell in a bear market and stay long term.
That’s why it’s important to understand your risk tolerance, your time horizon, and how the market works during recessions. Experiment with a stock simulator to identify your risk tolerance and insure against losses with diversification. Patience, not panic, is what you need to be a successful investor.
This article is not intended to provide investment advice. Investing in any security involves varying degrees of risk, which could lead to a total or partial loss of principal. Readers should seek the advice of a qualified financial professional to develop an investment strategy tailored to their particular needs and financial situation.