How to Handle a Market Downturn
For the past decade, the U.S. stock market has been on a bull run, with stock prices trending up and indexes such as the Dow Jones Industrial Average and the S&P 500 reaching all-time highs. However, markets naturally operate in cycles, with some periods of growth and some periods of market downturns. Thus, at some point, the current bull market is likely to end, and a bear market (generally considered to be a decline of 20% or more) will likely begin.
Yet predicting when these shifts will happen is impossible, and just because the market has been up for a while doesn’t mean that we’re “due” for a market decline. While there are warning signs of a potential recession that could trigger a downturn, such as with the yield curve inverting, the economy could improve and stock prices could continue to go up for the next several years.
As such, investors tend to be better off if they stay the course and maintain a long-term investment outlook to reach their goals, rather than trying to do too much in anticipation of a market downturn or even during a stock market crash.
Common Mistakes to Avoid Before and During a Stock Market Downturn
1. Overtrading or Trying to Time the Market
Overtrading tends to happen more today than in the past due to the ease and relatively low cost of online trading, but moving in and out of investments before and during a downturn to try to outsmart the market tends to be a losing proposition. Other times, such as in the current environment when the market continues to reach new highs, you’ll raise your average investment price, but you’ll gain the benefit of being invested in the market as it climbs, rather than incorrectly guessing where the top is. Generally, this approach leads to stronger returns in the long run.
Even if you think a downturn is about to occur, overtrading can trigger transaction fees and taxes that cut into your returns, and generally, you’re not going to be able to time the market successfully. Many studies, such as this one from the Center for Retirement Research at Boston College, show that timing the market leads to underperformance.
Deviating from your long-term investment strategy to overtrade, such as switching between investing in stocks and holding cash, can cause you to miss out on days when the market goes up, while you might be left holding the bag on days when the market goes down.
Other times, such as in the current environment when the market continues to reach new highs, you’ll raise your average investment price, but you’ll gain the benefit of being invested in the market as it climbs, rather than incorrectly guessing where the top is. Generally, this approach leads to stronger returns in the long run.
Related to overtrading is panicking. If you don’t stay committed to your long-term investment outlook with an eye on your financial goals, you might panic-sell during a market downturn, thereby locking in losses. Conversely, you may panic about missing out on investment gains and overinvest when the market is near its high.
Here, too, investing regularly to dollar-cost average can help you more smoothly ride out the ups and downs of the market. Moreover, if you have a solid financial plan in place before a market downturn occurs, which includes knowing that your investments are designed to grow over several decades, then you may be less tempted to panic-sell during a stock market crash. Give your investments time, and generally they will recover and help you reach your long-term financial goals.
3. Sticking Your Head in the Sand
While you don’t want to panic, you also don’t want to completely ignore what’s happening in the market. If you never look at your financial statements, even during severe downturns such as what occurred in 2008–2009, then you may miss certain occasions where you do want to adjust your investment strategy. Sticking your head in the sand can indicate a general discomfort with your finances, whereas you ideally want to feel confident in your long-term investment outlook whether the market is up or down.
That still doesn’t mean you want to trade a lot, but if you’re aware of how your investments perform during a market downturn, you may realize you’re uncomfortable with how much risk you’re taking on or something else about your investment strategy that you’d prefer to adjust.
Sticking your head in the sand can indicate a general discomfort with your finances, whereas you ideally want to feel confident in your long-term investment outlook whether the market is up or down.
4. Being Overconfident
At the other end of the spectrum, you also want to avoid being overconfident before, during, and after a market downturn. For one, don’t assume that past performance guarantees future results. In other words, being overconfident that the market will continue its bull run forever will likely lead to disappointment.
Moreover, being overconfident about a recovery following a market downturn can also be harmful. Although staying the course and waiting for the market to recover can help you reach your financial goals, there’s no guarantee how quickly that will occur or if the investments will return to their previous levels, particularly when looking at investments in specific companies.
Sometimes you have to cut your losses, or something may change in your lifestyle where you’d be better off adjusting your investment strategy too. Having some degree of humility can help you realize when it’s time to make a change.
To help avoid investing mistakes before and during a market downturn, it helps to plan ahead. Have an investment strategy that you can follow in both good times and bad, such as investing 15% of your paycheck into a mix of index funds in your retirement account each month to dollar-cost average, while also having a plan for how much volatility you can handle.
For example, you may be comfortable with a market downturn that lasts a few months and causes a 10% drop in your portfolio, but you may be uncomfortable with a bear market that lasts for a couple of years and causes a 30% drop in your portfolio. In that case, you may want to plan ahead by diversifying your portfolio or investing in low-volatility assets.
At the same time, no plan needs to be set in stone. Stay aware of what’s happening in both the market and in your life, and be prepared to make shifts that help you reach your financial goals. Consulting with a trusted source such as a financial advisor can help you realize when you’re getting off track from your financial goals while also helping you stay the course when you’re getting more worried than you need to be.
If you’d like to discuss how to handle a market downturn or have any other financial planning questions, reach out to the team at Financial Dynamics for some guidance. You can call us anytime at 804-777-9999. Or simply text the word “tips” to that number, and we’ll be sure to respond back to you shortly.
You can also listen to our podcast where we discuss these mistakes to avoid regarding a market downturn in more detail.
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The information contained in this presentation does not purport to be a complete description and is intended for informational purposes only. Any opinions are those of the content creator and not necessarily those of the named advisor(s) or JWCA. This information is not intended as a solicitation or an offer to buy or sell any security or investment product. Information is solely intended for recipients in jurisdictions where the named advisor(s) are licensed to engage the investing public. Investments and strategies mentioned may not be suitable for all investors. The S&P 500 and other such indices are unmanaged, do not incur fees or expense, cannot be invested into directly and individual investor’s results will vary. Past performance is no guarantee of future results. As with all investments, various risks may exist and JWCA recommends you consult with your financial advisor prior to making any investment decisions. Advisory Services offered through J. W. Cole Advisors, Inc (JWCA). Financial Dynamics & Assoc. Inc and JWCA are unaffiliated entities.