One of the biggest mistakes long-term investors make is getting out of the stock market at the wrong time. We’ve all heard the saying “buy low, sell high,” but mom-and-pop investors have a tendency to panic during market declines and sell when stock prices are down, locking in losses.
U.S. stocks have ridden a rising trend for six years as of March, a long stretch by historical standards. While that doesn’t guarantee the stock market will crash anytime soon, it’s always wise to review strategies to handle a declining market. If you are prepared, you can avoid emotional decision-making, which can be detrimental to your financial health, experts say.
Declining stock markets often bring out strong emotions such as fear, anxiety and depression, says Dr. Gary Dayton, a psychologist and founder of Glastonbury, Connecticut-based TradingPsychologyEdge.com, a trading psychology coaching firm. “Making investment decisions based on emotions is always the worst way to invest,” he says.
While institutional investors look at market downturns as buying opportunities, individual investors often sell their investments. “This striking tendency has been documented for over 100 years. At some point in a falling market, individual investors’ fear will be at its highest. Frightened at the prospect of losing even more money, many investors panic and sell their holdings,” Dayton says.
For individuals investing for retirement, with a time horizon of 10, 20 or 30 years, short-term bear cycles may not matter. The problem for long-term investors who sell in market declines is getting back into the market without missing the upturn.
“Numerous studies have shown that investors tend to panic during declines and at bottoms. It hurts because once markets recover, they tend to go up quite rapidly before investors realize that things are going back to normal,” says David L. Blain, chief executive officer of BlueSky Wealth Advisors LLC, a New Bern, North Carolina-headquartered wealth advisory firm. “By then, they have missed out on a large portion of the upside.”
The herd mentality also can play a part in stock market selling pressures. “Herding is the tendency of a group of market participants to behave like a school of fish or a flock of birds. When market conditions deteriorate, there is an initial rush to the exits,” says Dr. Kenneth Reid, a trading coach and founder of Santa Fe, New Mexico-based DayTradingPsychology.com.
To avoid becoming a casualty of the herd and selling at the wrong time, consider employing these six strategies in a declining stock market.
1. Turn off the news. Listening to the news and reading about the dire economic predictions can heighten your nervousness. “Don’t look at your portfolio all the time. Turn off the TV and stop listening to your neighbor and the doom-and-gloom prognosticators. Focus on what you can control, which is your spending and saving. Make a new goal to save an extra X dollars a month while things are declining, and then invest it,” Blain says.
2. Reevaluate your portfolio. Do the stocks you hold continue to meet your investment criteria? “Winnow out the weak stocks by selling them. Stocks that no longer meet strong investment criteria are likely to decline the most in a market fall. You will be increasing your cash position, which can be used for the purchase of new stocks at attractive prices once the decline is over,” Dayton says.
3. Make a list of stocks or funds you want to buy. A declining market can offer the opportunity to add to your long-term investment portfolio at a lower price point. “Long-term investors should welcome the occasional bear market if they have a good investment strategy and the discipline to see it through. The historical stock market trend is upward, and occasional bull markets are an opportunity to buy stocks while they are ‘on sale.’ As Warren Buffett observed, it is profitable to be greedy when others are fearful,” says Derek C. Hamilton, a certified financial planner at Indianapolis-based Elser Financial Planning Inc.
4. Stay diversified. A portfolio allocation with 60 percent stocks and 40 percent bonds is an old benchmark and starting point for portfolio diversification. Check out stock-and-bond mixes in a target-date fund based on your age to get an idea of appropriate allocations for your time horizon. Rebalancing your allocations is an important task you can do on a quarterly or annual basis so your portfolio will be ready if the market heads south. “If you have different asset classes, something will be going up. In the global financial crisis, it was U.S. Treasuries. The point is to determine ahead of time what sort of decline you can tolerate, and don’t invest in such a large percentage of stock that you will panic in a decline,” Blain says.
5. Work with a financial advisor. Develop a comprehensive, written plan that sets out your important financial goals and how you will achieve them. This will be your map when the going gets tough. “We are all human beings, and fear can get the better of us. The best inoculation against a fear-driven investment mistake is professional guidance and a good plan,” Hamilton says.
A fee-only financial adviser can help navigate you through a declining market. “He or she can help you avoid hasty, emotionally driven moves and see to it that any course corrections are well-considered and keep you on track to meet your goals,” Hamilton adds.
6. Get a grip on your emotions. You may not be able to avoid an emotional response, but you can manage it. “Science is showing that the practice of mindfulness helps us reduce stress, changes brain regions associated with fear and therefore improves our internal control over emotions, and helps us be more aware of both opportunities and dangers when we are in challenging situations such as declining stock markets,” Dayton says. “Mindfulness helps investors maintain an even emotional keel and make better investment decisions. It is the one mental skill I suggest all investors learn.”
He adds: “Following an investment process and being prepared for the inevitable market declines helps you act prudently, keep truly great companies in your portfolio for the long term, protect them during market slumps and be in a position to buy other great companies at attractive prices when others are selling them in panic.”
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