When the stock market goes down and the value of your portfolio decreases, it’s tempting to ask your financial advisor, “What should I do? Should I pull money out of the stock market?” That’s understandable but 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, leading to a drastic drop in the value of their hard-earned funds. It's important to know your risk tolerance and how it will affect the price fluctuations–called volatility–in your portfolio. Investors can protect themselves from market risk by hedging their portfolio through diversification, which includes holding a wide variety of investments.

Key Takeaways

  • Knowing your risk tolerance level will help you to choose the right investments and avoid panicking during an economic downturn.
  • Diversifying a portfolio with real estate or derivatives can insure against risk and market crashes.
  • Experimenting with stock simulators (before investing real money) can provide insight into the market's volatility and your 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 September 2019 Gallup survey? Gallup posits that the reason is lack of confidence in the market due to the 2008 financial crisis and the considerable market volatility of the previous year. However, a 2019 survey by GoBankingRates.com found that 55% of the people who don’t invest say that it is because they don’t have enough money. 

Of course, the results from any survey is somewhat dependent on whether the survey was conducted during a bull market–when the market is rising–or a bear market–when the market is falling. A stock market decline, due to a recession or an exogenous event, can put many investing tenets, such as risk tolerance and diversification, to the test.

If your reason is mistrust, 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 of 2009 and eventually rose to its former levels and well beyond. Panic sellers might have missed out on the market rise while long-term investors who remained in the market eventually recovered and fared better over the years. In other words, when stocks are going down, it's not the time to try and time the market.

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.

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. As a result, 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.

55%

The number of Americans who invest in the stock market as of September 2019

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. Blindly investing in just 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 invest in financial instruments known as derivatives and to look into alternative investments such as real estate. 

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.

However, 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.