When the stock market goes down and the value of your portfolio decreases, it’s tempting to ask yourself or your financial advisor (if you have one), “Should I pull money out of the stock market?” That’s understandable—but it's wrong. Instead, you should ask, “What should I not do?”

The answer is simple: Don’t panic. Panic selling is often people's first reaction when stocks are going down and there's a drastic drop in the value of their hard-earned funds. That's why it's important to know your risk tolerance and how price fluctuations—called volatility—in your portfolio will affect you. Investors also can help mitigate market risk by hedging their portfolio through diversification, which includes holding a wide variety of investments.

Key Takeaways

  • Knowing your risk tolerance will help you choose the right investments for you and avoid panicking during an economic downturn.
  • Diversifying a portfolio among a variety of asset classes can mitigate some 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.

Why Shouldn’t I Panic?

Investing helps you safeguard your retirement, put your savings to their most efficient use, and grow your wealth with compound interest. Why, then, do 45% of Americans choose not to invest in the stock market, according to a June 2020 Gallup survey? Gallup posits that the reason is a lack of confidence in the market due to the 2008 financial crisis and the considerable market volatility of the past year.

From 2001 to 2008 an average 62% of U.S. adults said they owned stock, a level never reached since, according to Gallup. A stock market decline, due to a recession or an exogenous event like the COVID-19 pandemic, can put many investing tenets, such as risk tolerance and diversification, to the test. It's important to remember that the market is cyclical and stocks going down is inevitable. But a downturn is temporary. It's wiser to think long-term, instead of panic selling when stock prices are at their lows.

Long-term investors know that the market and economy will recover eventually, and investors should be positioned for the eventual rebound. During the 2008 financial crisis, the market plummeted, and many investors sold off their holdings. However, the market bottomed in March 2009 and eventually rose to its former levels and well beyond. Panic sellers may have missed out on the market rise while long-term investors who remained in the market eventually recovered and fared better over the years.

The same goes for investors who panicked (or not) in March of 2020, when the stock market entered a bear market for the first time in 11 years amid the economic impacts of the global pandemic. Not only has the stock market rebounded, it has hit record highs several times since.

Instead of passing up the opportunity to have your money earning more money, formulate a bear market strategy to protect your portfolio from different outcomes. Here are two steps you can take to make sure that you do not commit the number one mistake when the stock market goes down.

When stocks are going down, it's not the time to try and time the market.

1. Understand Your Risk Tolerance

Investors can probably remember their first experience with a market downturn. Rapid drops in the price of an inexperienced investor’s portfolio are unsettling, to say the least. A way to prevent the ensuing shock is to experiment with stock market simulators before actually investing. With stock market simulators, you can manage $100,000 of “virtual cash” and experience the common ebbs and flows of the stock market. You can then establish your identity as an investor with your own particular tolerance for risk.

Your investing time horizon will help you determine your risk tolerance. If you're a retiree or at pre-retirement age, you'll likely want to preserve your savings and generate income in retirement. For example, retirees might invest in low volatility stocks or purchase a portfolio of bonds called a bond ladder. However, millennials might invest for long-term growth since they have many years to make up for any losses due to bear markets.

Investing in the stock market at pre-determined intervals, such as with every paycheck, helps capitalize on an investing strategy called dollar-cost averaging. Dollar-cost averaging, simply stated, averages your cost of owning a particular investment by purchasing shares during periods when the market is high, as well as during periods when the market is low, rather than attempting to time the market.

2. Prepare for—and Limit—Your Losses

In order 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.

Ultimately, you should be ready for the worst and have a solid strategy in place to hedge against your losses. Investing exclusively in stocks may cause you to lose a significant amount of money if the market crashes. To hedge against losses, investors strategically make other investments to spread out their exposure and reduce their risk.

Of course, by reducing risk, you face the risk-return tradeoff, in which the reduction in risk also reduces potential profits. A few ways to hedge against risk are to diversify your portfolio and to look into alternative investments such as real estate. Having a percentage of your portfolio spread among stocks, bonds, cash, and alternative assets is the core 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.

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 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. Patience, not panic, is what you need to be a successful investor.

This article is not intended to provide investment advice. Investing in any security involves varying degrees of risk, which could lead to a partial or total loss of principal. Readers should seek the advice of a qualified financial professional in order to develop an investment strategy tailored to your particular needs and financial situation.