When the stock market goes down and the value of our portfolio decreases, it's tempting to ask our finance advisors what we should do. Instead, we should be asking: What should I not do?

For example, don't panic. This is often our first reaction to a drastic drop in the value of our hard-earned funds. To prevent this unfortunate situation, know your risk tolerance and how this will affect the volatility of your portfolio. Then, hedge against the risk of a drop in the market by diversifying your portfolio.

Knowing your risk tolerance and creating a portfolio and strategy that reflects your tolerance level will help you to avoid panicking in the event of a market downturn.

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 close to 50% of Americans choose not to invest in the stock market? A 2016 report by Gallop concludes that investors were spooked by the financial crisis and have little confidence in the stock market. 

A downturn in the market is a temporary thing. Thus, it is better to think long term than to panic and sell stock at a low during a downturn. Have a strategy for different outcomes instead. Here are a few steps you can take to make sure that you do not commit the number one mistake when the stock market goes down.

Key Takeaways

  • Knowing your risk tolerance level will help you to choose the right investments and to 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 give you an idea of the volatility of the stock market and your response to it.

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 are unsettling to say the least. A way to prevent the ensuing shock is to experiment with stock market simulators before investing for real. 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 decide whether you should sell or buy more.

52%

The number of Americans who invest in the stock market.

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 will cause you to lose everything if the market indeed crashes. To hedge against losses, investors buy insurance, but they also strategically make other investments.

Of course, by reducing risk, they 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

A market crash can be mentally devastating, particularly for the inexperienced investor. Panicking when your portfolio decreases drastically and selling is the worst thing to do. Avoid such a mistake by understanding how the market works and setting a personal risk tolerance. 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.