Investing in stocks offers the potential for superior returns over time, but it can be a rollercoaster ride. The stock market is volatile in nature, and price fluctuations are an inevitable reality — in fact, the average market fluctuation is around 15% every year.
It’s easy to stay the course when the market is headed upward. Every time you check your portfolio performance, you see that positive number and feel good knowing your net worth is increasing. But what happens when that number turns negative? What do you do when you check your portfolio and realize it’s down 10% or more?
When your investment portfolio takes a significant hit, it’s crucial to keep a level head and have a plan in place. Here are three things investors should do when that happens.
The first and most important thing to do when your investment portfolio sees a big decline is to resist the urge to panic. Market volatility is a natural part of investing, and it’s important to remember that stock prices can fluctuate for various reasons, including economic conditions, geopolitical events and investor sentiment.
Legendary investor Warren Buffett said it best: “You’ve got to be prepared when you buy a stock to have it go down 50% or more and be comfortable with it, as long as you’re comfortable with the holding.”
Often, a stock market downturn will send the stock prices of most or all companies lower, even if nothing about them has changed. It can be scary to see the value of your portfolio decline, especially if it happens quickly, but nothing good can come from panic-selling, which usually leads to locking in losses and missing out on potential recoveries. Instead, focus on your long-term investment goals. When you take the long view, there’s no need to make impulsive decisions during a downturn.
One effective strategy to manage panic is to maintain a diversified portfolio. Diversification spreads risk across different asset classes, reducing the impact of a decline in any one investment. A diversified portfolio is less likely to experience extreme declines, which can help you stay calm during turbulent times.
Look For Opportunity…
While a declining market may seem like a bleak situation, it can also present opportunities for savvy investors. The second essential move during a sharp downturn is to adopt a proactive mindset and look for opportunities amid the chaos. As Baron Rothschild famously said, “Buy when there’s blood on the streets, even if the blood is your own.”
One opportunity is to buy quality stocks at a discount. When market values drop, many fundamentally strong companies become undervalued. By identifying these opportunities and adding them to your portfolio, you can potentially benefit from their future growth when the market recovers.
Additionally, consider rebalancing your portfolio during a market decline. If certain asset classes have declined significantly, your portfolio’s allocation may have shifted away from your desired balance. Rebalancing involves selling some of the assets that have performed well and reallocating the proceeds to assets that have underperformed. This disciplined approach can help you take advantage of lower prices and maintain your target asset allocation.
…But Don’t Try To Time the Market
One of the biggest mistakes investors make during a market decline is attempting to time the market. Timing the market involves trying to predict when the market will hit its bottom or peak and making investment decisions based on these predictions. This strategy is notoriously difficult, even for experienced professionals.
Vanguard founder John Bogle once said of market timing that “[a]fter nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.”
Instead of trying to time the market, focus on time in the market. Stay invested and stick to your long-term investment plan. Historically, the stock market has always shown a tendency to recover from downturns and continue its long-term upward trajectory. It may take time, but by staying invested, you give your investments the opportunity to recover and grow over time.
Preparing Yourself for a Downturn
The best way to be sure you take the right steps when your portfolio declines — and it will at some point — is to prepare for it in advance by having a comprehensive plan.
Robert Johnson, PhD, CFA and professor of finance at Creighton University’s Heider College of Business, has decades of experience in the stock market, both as an academic and as an investor. He says that every investor should have an Investment Policy Statement (IPS) to guide them.
“An IPS is a written document that clearly sets out a client’s return objectives and risk tolerance over that client’s relevant time horizon, along with applicable constraints such as liquidity needs and tax circumstances. In essence, an IPS sets out the ground rules of the investment process — it is the document that guides the investment plan,” Johnson said. He notes that a good IPS should cover a number of topics.
- Define your investment objectives: Start by clearly stating your financial goals. Are you saving for retirement, a major purchase or a child’s education? Your objectives will guide your investment strategy.
- Assess your risk tolerance: Determine how much risk you are comfortable taking. Consider your financial situation, time horizon and emotional tolerance for market fluctuations. Your risk tolerance will help you select appropriate investments.
- Set asset allocation guidelines: Decide how you will distribute your investments among different asset classes, such as stocks, bonds and cash. Asset allocation is a critical factor in determining your portfolio’s risk and return potential.
- Choose investment vehicles: Select specific investments, such as individual stocks, mutual funds or exchange-traded funds (ETFs), that align with your asset allocation and risk tolerance.
- Establish a monitoring and rebalancing strategy: Outline how often you will review your portfolio and make adjustments as needed. Regular monitoring ensures that your portfolio stays aligned with your IPS.
- Determine your investment horizon: Specify your time horizon for each investment goal. Short-term goals may require more conservative investments, while long-term goals can accommodate a higher degree of risk.
Johnson recommends creating your IPS with the help of a professional financial planner or advisor. Although very knowledgeable investors may be comfortable doing it on their own, this is a critical part of your investing journey, so it’s a good idea to have a seasoned pro help you through it. It’s also best to develop it during a calm period in the stock market.
“Developing an IPS in a volatile market or during major stories is problematic. The whole point of an IPS is to guide you through changing market conditions. It should not be changed as a result of market fluctuations. It only needs to be revised when your individual circumstances change — perhaps a divorce or other unanticipated life change,” Johnson said.
Remember, it’s absolutely essential to stay committed to your IPS. During market downturns, refer to your IPS to remind yourself of your long-term goals and strategy. This way you’re sure to do the smart thing and avoid making impulsive decisions based on short-term market fluctuations.
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