Investing can induce stress as we strive to make optimal choices for our financial futures. However, it can be difficult to navigate through volatile market conditions. Specifically, individual investors often ponder how they should react when the market experiences a downturn or experts forewarn of an upcoming recession.
During uncertain times, you may contemplate moving your investments from stocks and stock funds to cash. However, the decision to do so would depend on which portion of your investment portfolio you are referring to.
When it comes to the part of your investment collection that you use to cover expenses, like your child’s tuition bill that is due soon, it may be wise to convert those assets into cash. This is because if you have to make a payment of $25,000 at the beginning of the next month, it would not be feasible to have a balance of only $20,000.
The term “cash” can refer to actual physical currency, like money in a bank account or a money market fund, or it can include short-term bonds or bond funds that have relatively stable values similar to cash.
However, what about your savings for the future? What about the accounts that you are using to save for your retirement, which may be several years or even decades away? Going all in on cash is not the right approach for this long-term part of your investment portfolio.
Is it advisable to sell your stocks when prices are going down?
What makes cashing out the incorrect decision for the long-term section of your portfolio? Why not consider selling stocks and stock funds to prevent further financial losses?
Experienced investors, who may have become accustomed to market fluctuations, still experience distress when their investment portfolios decrease in value. However, it is important to differentiate between losing value and losing actual money. The losses incurred are only considered real and tangible once the investments are sold.
Certain investors hold the belief that they can navigate challenging market situations by selling their investments during a decline and then waiting for a more favorable market outlook before reinvesting. However, the practice of accurately predicting the right time to enter or exit the market is extremely challenging, and even experts who make such attempts often meet with failure. This is particularly the case when it comes to investment funds.
Sell High, Buy Low?
When attempting to predict the right time to invest in the stock market, investors, particularly those who depend on funds such as regular savers with retirement accounts, often make the mistake of selling their assets when prices are low, thus securing their losses. Additionally, they also miss out on potential gains by not being active in the market when it experiences a rally.
This is because rallies usually start suddenly, and individual investors often hesitate to re-enter the market. They fear that these new rallies are just temporary and have been mocked as “dead-cat bounces” by investors for a long time.
The Dalbar Quantitative Analysis of Investor Behavior report reveals that in the challenging year of 2020, the average stock investor experienced a 17.29% increase, reaffirming the accuracy of numbers in this context. While this gain is not considered poor, it falls slightly short of the overall market performance, which saw an 18.40% increase.
The disparity worsened in 2021 as the average value of stock investments for individual investors increased by 15.25% during the first half of the year. However, this growth was less than the overall market’s advancement of 17.36%.
Why the gap?
According to Corey Clark, the Chief Marketing Officer at Dalbar, individual investors have a tendency to make poor decisions when trying to time the market. They often sell when prices are low and buy when prices are high. In addition, their judgment is generally flawed, as their losses in the market tend to be much larger than their gains. This suggests that the main issue lies in the fact that they often make more incorrect guesses than correct ones.
Learning to Live With Volatility
Following any decrease in the market, regardless of its severity, the market has consistently regained its value. Similarly, investment portfolios that are properly diversified also bounce back. Consequently, it is unnecessary and detrimental to continuously enter and exit the market, as it negatively affects the performance of your portfolio.
In the stock market, experiencing market volatility is a normal occurrence that individuals need to accept. According to experts, it is essential to either tolerate or minimize its effects to a manageable extent.
During the early years of the 21st century, the bursting of the dot.com bubble resulted in a significant decline of almost half in the value of the S&P 500 Index. Following that, the Great Recession that took place from 2007 to 2009 led to a nearly 60% drop in the value of the index. More recently, the outbreak of the Covid-19 pandemic caused the S&P 500 to rapidly decline in March 2020, with a decrease of 34% within just one month.
However, after each of those declines and subsequent bear markets, there was a subsequent upward movement. The S&P 500 not only recovered but also exceeded previous peak levels. On average, bear markets since 1929 have experienced declines of 37.3%. On the other hand, the subsequent bull markets since 1921 have seen average gains of 164%, as indicated by Sam Stovall, the chief investment strategist at CRFA Research.
The clear takeaway is that investors who stay invested for a long time are rewarded by the market.
Stay disciplined even when dealing with unpredictable situations.
It is evident that there are advantages to staying disciplined and adhering to your strategy during market fluctuations. However, for a lot of individuals, there is a disconnect between knowing what is right and actually taking the appropriate actions.
Studies indicate that the distress caused by losing money is more powerful than the satisfaction gained from financial gains. Emotions and cognitive biases play a significant role in this phenomenon, making it challenging to overcome. However, there are measures you can adopt to fortify your determination amidst fluctuating market conditions.
Establish your objectives and develop a strategy for managing your finances.
Saving for retirement is the primary financial goal for the majority of investors. However, there are other long-term objectives such as saving for education or purchasing a house, as well as shorter-term goals like starting a business.
Every person has their own financial objectives, which can change depending on different experiences in life. However, stocks play a major role in achieving long-term growth in your investment portfolio, so it is crucial to stay committed and focused in order to accomplish your desired outcomes.
Creating and abiding by a financial strategy is the most effective approach to attain your goals. Numerous investors find it challenging to resist the temptation of selling during times of economic strain and market instability. However, it is crucial to adhere to your long-term plan.
One of the most effective methods to stay focused is to collaborate with an expert financial advisor. They can assist you in devising a strategy and ensuring that you remain committed even during challenging times.
Understand Your Risk Tolerance
Creating an investment plan involves considering important factors such as your financial goals, how long you intend to invest, and your willingness to take on risks.
Among the three factors, determining risk tolerance can be the most challenging. It refers to the extent of risk that you are willing to undertake in order to attain a specific level of profit. However, it is crucial to ascertain your risk tolerance as it directly impacts your potential return. The greater the level of risk you are willing to assume in your investments, the greater the potential profits you may earn.
Additionally, having an understanding of your ability to tolerate risk assists in developing an investment portfolio that steadily increases in value without exposing you to excessive market fluctuations that may cause discomfort. The growth of your portfolio is crucial as it enables you to achieve your desired objectives, whether they pertain to retirement, education, travel, housing, or any other aspirations.
What actions should you take when you require assistance with your investments?
If you are unsure about understanding your willingness to take risks or how it aligns with your objectives and timeframe, seeking the assistance of a financial advisor can be beneficial. They possess the expertise to inquire about specific aspects and guide you in questioning your own assumptions, allowing you to evaluate and modify them accordingly.
If you feel anxious about making financial decisions and the idea of your portfolio losing value during market downturns makes your heart race, it is crucial to acknowledge these emotions and adopt strategies to control your reactions and stay committed to your financial plans.
An experienced financial advisor and a well-diversified investment portfolio can be beneficial in navigating different market conditions. Having a conversation beforehand about potential market downturns can help develop appropriate strategies to implement when the market becomes volatile.
Focus on Asset Allocation
A brief examination of the past performance of the S&P 500 illustrates the significance of stocks in attaining financial goals over a considerable period of time.
Over the course of the 30-year period leading up to 2022, stocks consistently outperformed bonds, as indicated by the graph. Stocks, represented by the S&P 500, had an average annual growth rate of 11.25%, which is nearly two and a half times higher than the more modest average annual growth rate of 4.7% for bonds, represented by the Bloomberg US Aggregate Bond Index.
In 22 out of the 30 years, stocks performed better than bonds. If you had invested $10,000 at the beginning, by the end of December last year, your total amount would have grown to over $158,000. This assumption is based on a hypothetical S&P 500 Index fund that does not charge any fees and is held within a tax-deferred retirement account.
If you had put your money into a similar imaginary bond fund on Bloomberg Agg with no fees or taxes, your final balance would have increased to approximately $38,000. This serves as a reminder that stocks have a much higher growth potential compared to bonds in the long run.
Using Bond Funds as Shock-Absorbers
However, it is beneficial to incorporate bonds, and bond funds can make it more convenient to do so. Why is this a good idea? Diversification is crucial for effectively attaining your goals and safeguarding against risk and fluctuation. By diversifying your investment portfolio, you can shield yourself from the negative impact of a declining stock market.
Including fixed income investments as a component of a diversified strategy is common, but bonds generally produce less profit than stocks. Additionally, adding alternative investments such as real estate, which tend to perform well during times of poor stock market performance, can also enhance the overall balance of your investment portfolio.
Take another look at the image above. It illustrates that the S&P 500 Index, representing stocks, generally experiences quicker growth compared to bonds. However, bonds can be utilized as a cushion to decrease the overall volatility of a portfolio. This is particularly useful if you aim to lessen the extreme fluctuations that stocks often undergo in various years.
Benefits of Diversification
A commonly used strategy to capitalize on the growth potential of stocks while balancing it with the stability of bonds is to have a combination of 60% stocks and stock funds and 40% bonds and bond funds. This allocation can be modified based on your own risk tolerance.
To create an effective portfolio, it is important to include a variety of assets that do not have a related performance. For example, within your investment in stocks, you can enhance diversification by increasing the allocation of defensive stocks. These stocks tend to have slower growth compared to high-growth technology stocks. However, they also provide a more stable investment experience as they are less affected by market fluctuations.
Best Way to Build Long-Term Wealth
While investing in the stock market may induce stress, it is undoubtedly the most effective means of accumulating wealth in the long run.
From 1926 until July 31, large-cap stocks within the S&P 500 Index have achieved an average annual return of over 10%. Similarly, small-cap stocks have shown an average return of almost 12%. These gains have been consistent despite experiencing challenging periods of volatility and economic downturn, including the Great Depression, World War II, the dot-com bubble burst, and the Great Recession.
Experiencing the decline of your portfolio’s value in the short term can be distressing. However, it is important to resist the harmful temptation to sell during challenging times. Past events have demonstrated that disciplined investors are ultimately rewarded by the market.