When the stock market goes down and the value of your portfolio decreases significantly, it’s tempting to ask yourself or your financial advisor (if you have one), “Should I pull my money out of the stock market?” That’s understandable, but most likely not the best course of action. Instead, you should perhaps be asking, “What should I not do?”
The answer is simple: Don’t panic. Panic selling is often people’s gut reaction when stocks are plunging and there’s a drastic drop in the value of their portfolios. That’s why it’s important to know beforehand your risk tolerance and how price fluctuations—or volatility—will affect you. You can also mitigate market risk by hedging your portfolio through diversification—holding a variety of investments including some that have a low degree of correlation with the stock market.
Key Takeaways
- Knowing your risk tolerance beforehand will help you choose investments that are suitable for you and prevent you from panicking during a market downturn.
- Diversifying a portfolio among a variety of asset classes can mitigate risk during market crashes.
- Experimenting with stock simulators (before investing real money) can provide insight into the market’s volatility and your emotional response to it.
Why Shouldn’t I Panic?
Investing helps you safeguard your retirement, put your savings to their most efficient use, and grow your wealth through the magic of compounding. Why, then, do 44% of Americans not invest in the stock market, according to a July 2021 Gallup survey? Gallup posits that the reason is a lack of confidence in the market due to the 2008 financial crisis and the considerable market volatility of the past year. Additionally, those without sufficient savings to get by month-to-month generally don't have money to invest in the market either.
From 2001 to 2008, an average 62% of U.S. adults said they owned stock—a level never reached since, according to Gallup. A stock market decline, due to a recession or an exogenous event like the COVID-19 pandemic, can put core investing tenets, such as risk tolerance and diversification, to the test. It’s important to remember that the market is cyclical and stocks going down are inevitable. But a downturn is temporary. It’s wiser to think long-term instead of panic selling when stock prices are at their lows.
Long-term investors know that the market and economy will recover eventually, and investors should be positioned for such a rebound. During the 2008 financial crisis, the market plummeted, and many investors sold off their holdings. However, the market bottomed in March 2009 and eventually rose to its former levels and well beyond. Panic sellers may have missed out on the market rise, while long-term investors who remained in the market eventually recovered and fared better over the years.
More recently, the plunged by a gut-wrenching 35% in just over a four-week period in March 2020, when the stock market entered a bear market for the first time in 11 years amid the economic impacts of the global pandemic. The index not only rebounded swiftly from those lows but has also hit record highs several times since.
Instead of panicking and locking in your losses by selling at the lows during a steep market correction, formulate a bear market strategy to protect your portfolio at such times. Here are three steps you can take to make sure that you do not commit the No.1 mistake when the stock market goes down.
1. Understand Your Risk Tolerance
Investors can probably remember their first experience with a market downturn. For inexperienced investors, a rapid decline in the value of their portfolios is unsettling, to say the least. That is why it is very important to understand your risk tolerance beforehand when you are in the process of setting up your portfolio, and not when the market is in the throes of a sell-off.
Your risk tolerance depends on a number of factors, such as your investment time horizon, cash requirements, and emotional response to losses. It is generally assessed through your responses to a questionnaire; many investment websites have free online questionnaires that can give you an idea of your risk tolerance.
One way to understand your reaction to market losses is by experimenting with a stock market simulator before actually investing. With stock market simulators, you can invest an amount such as $100,000 of virtual cash and experience the ebbs and flows of the stock market. This will enable you to assess your own particular tolerance for risk.
Your investing time horizon is an important factor in determining your risk tolerance. For instance, a retiree or someone nearing retirement would likely want to preserve savings and generate income in retirement. Such investors might invest in low-volatility stocks or a portfolio of bonds and other fixed-income instruments. However, younger investors might invest for long-term growth because they have many years to make up for any losses due to bear markets.
2. Prepare for—and Limit—Your Losses
To invest with a clear mind, you must grasp how the stock market works. This permits you to analyze unexpected downturns and decide whether you should sell or buy more.
Ultimately, you should be ready for the worst and have a solid strategy in place to hedge against your losses. Investing exclusively in stocks may cause you to lose a significant amount of money if the market crashes. To hedge against losses, investors strategically make other investments to spread out their exposure and reduce their risk.
Of course, by reducing risk, you face the risk-return tradeoff, in which the reduction in risk also reduces potential profits. Downside risk can be hedged to quite an extent by diversifying your portfolio and using alternative investments such as real estate that may have a low correlation to equities. Having a percentage of your portfolio spread among stocks, bonds, cash, and alternative assets is the essence ofdiversification. Every investor’s situation is different, and how you divvy up your portfolio depends on your risk tolerance, time horizon, goals, etc. A well-executed asset allocation strategy will allow you to avoid the potential pitfalls of placing all your eggs in one basket.
3. Focus on the Long Term
Reams of research prove that though stock market returns can be quite volatile in the short term, stocks outperform almost every other asset class over the long term. Over a sufficiently lengthy period, even the biggest drops look like mere blips in the market's long-term upward trend. This point needs to be borne in mind especially during volatile periods when the market is in a substantial decline.
Having a long-term focus will also enable you to perceive a big market drop as an opportunity to build wealth by adding to your holdings, rather than as a threat that will wipe out your hard-earned savings. During major bear markets, investors sell stocks indiscriminately regardless of their quality, presenting an opportunity to pick up select blue chips at attractive prices and valuations.
If you're concerned that this approach may be tantamount to market timing, consider dollar-cost averaging. With dollar-cost averaging, your cost of owning a particular investment or asset—such as an index ETF—is averaged out by purchasing the same dollar amount of the investment at periodic intervals. Because these periodic purchases will be made systematically as the asset's price fluctuates over time, the end result may be a lower average cost for the investment.
Investing in the stock market at predetermined intervals, such as with every paycheck, helps capitalize on an investing strategy called dollar-cost averaging. With dollar-cost averaging, your cost of owning a particular investment is averaged out by purchasing the same dollar amount at periodic intervals, which may result in a lower average cost for the investment.
If the Stock Market Looks Like It Could Crash, Should I Sell All My Stocks and Wait to Buy Them Back When the Market Stabilizes?
This "market timing" strategy might sound easy in theory but is extremely difficult to execute in practice because you need to get the timing right on two decisions—selling, and then buying back your positions. By selling all your positions and going to cash, you risk leaving money on the table if you sell too early.
As for getting back into the market, the bottoming-out process for stocks typically takes place amid a plethora of negative headlines, which may lead to second-guessing your own decision to buy. As a result, you might wait too long to get back into the market, by which time it may have already advanced considerably. As most seasoned investors will tell you, time in the market, and not (market) timing, is key to successful investing, because missing the market's best days—which are impossible to predict—is very detrimental to portfolio performance.
Do Bonds Go Up When the Market Crashes?
Generally, but not all the time. The bonds that do best in a market crash are government bonds such as U.S. Treasuries; riskier bonds like junk bonds and high-yield credit do not fare as well. U.S. Treasuries benefit from the "flight to quality" phenomenon that is apparent during a market crash, as investors flock to the relative safety of investments that are perceived to be safer. Bonds also outperform stocks in an equity bear market as central banks tend to lower interest rates to stimulate the economy.
Should I Invest in the Stock Market If I Need the Money Within the Next Year to Buy a House?
Emphatically, No. Investing in the stock market works best if you are prepared to stay invested for the long term. Investing in stocks for less than a year may be tempting in a bull market, but markets can be quite volatile over shorter periods. If you need the funds for the down payment on your house when the markets are down, you risk the possibility of having to liquidate your stock investments at precisely the wrong time.
The Bottom Line
Knowing what to do when stocks go down is crucial because a market crash can be mentally and financially devastating, particularly for the inexperienced investor. Panic selling when the stock market is going down can hurt your portfolio instead of helping it. There are many reasons why it’s better for investors to not sell into a bear market and stay in for the long term.
This is why it’s important to understand your risk tolerance, your time horizon, and how the market works during downturns. Experiment with a stock simulator to identify your tolerance for risk and insure against losses with diversification. You need patience, not panic, 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 partial or total loss of principal. Readers should seek the advice of a qualified financial professional in order to develop an investment strategy tailored to their particular needs and financial situation.
