When the stock market goes down, and the value of our portfolio decreases, many of us look around and try to ask our advisors, friends and family, what we should do. In this case, we are asking the wrong question. Instead, we should be addressing the more important question – what should we not do?
The best answer is not to panic. Which, for most people, is their first reaction to seeing a drastic drop in the value of their hard-earned funds. To prevent this uncomfortable situation, make sure you understand your individual risk tolerance and how this will affect the volatility of your portfolio. Looking ahead, you should hedge against the risk of such an event by diversifying your portfolio and insuring against a stock market loss.
What Happens When You Panic? Why You Shouldn't Panic?
Investing helps us safeguard our retirement, put our savings to their most efficient use, and grow our wealth with compound interest. Why, then, do 45% of Americans choose not to invest in the stock market? A 2015 report by Gallop concluded that “investors were spooked by the big losses in stock values that occurred after the financial crisis, and many have likely decided the risks in stock investing are too great.”
First of all, panicking will do nothing but spike your stress hormones and cloud your logical reasoning. You must detach yourself from obsessively checking your portfolio value, and in the case of a large market downturn, have the knowledge and resources available for you to try and understand the cause. If panic takes over and you decide to sell all of your stock in a market downturn, you will lock in a loss.
Instead of stressing out and pulling your money out of your portfolio when it hits an all-time low, you should have a game plan in place for all types of outcomes that can occur. Here are a few steps you can take to make sure that you do not commit the number one mistake you can make when the stock market goes down.
Understanding Your Risk Tolerance
Investors can probably all remember their first experience with a market downturn. Rapid drops in the price of an early investor’s portfolio can take them aback. A fantastic way to prevent this shock is to play around with stock market simulators before starting with the real thing. With stock market simulators, individuals 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.
Prepare For and Limit Your Losses
In order to invest with a clear mind, you must grasp how the stock market works. This way you can analyze unexpected downturns and choose whether or not that means you should sell, or whether it’s a great opportunity to buy more. (For related reading, see: Can You ‘Learn’ The Stock Market?)
That being said, you ultimately should be ready for the worst and have a solid strategy in place to hedge against your losses and a mental breakdown. Blindly investing in just stocks will put you between a rock and a hard place if the market indeed crashes. To hedge against losses, investors don’t simply buy insurance, but they strategically make other investments. Of course by reducing risk, they run into the risk-return tradeoff, in which the reduction in risk will result in a reduction of 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
A market crash can translate into a personal meltdown, especially for the inexperienced investor. When it comes to taking action when your portfolio decreases drastically, it’s detrimental to panic and sell all of your stock. To eliminate stress and make sure you do not irrationally lock in a loss, you must first understand how the market works and set a personal risk tolerance. Many strategies for doing so exist, such as playing around with a stock simulator and insuring against losses with diversification. When it comes to your hard-earned dollars, it seems counter-intuitive to take the back seat. However, patience is panic's antithesis, and just what you need to be a successful investor.