One Thing Never to Do When the Stock Market Goes Down

Don’t panic. Have a strategy in place.

TABLE OF CONTENTS

• 1. Understand Your Risk Tolerance

• 2. Prepare for—and Limit—Your Losses

• 3. Focus on the Long Term

• FAQs

• The Bottom Line

When the stock market goes down and the value of your portfolio decreases significantly, it’s tempting to you to act?

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.

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.

Having a percentage of your portfolio spread among stocks, bonds, cash, and alternative assets is the essence of diversification. 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.

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.

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.

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.

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?

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.