By Dan Hunt, Senior Investment Strategist
As troubling as the market sell-offs can be, at least one feature feels familiar to me: The effort to convince investors to avoid the serious investing mistakes that come from short-term thinking during a sell-off.
These are some of the top mistakes investors typically make and my suggestions for what to do instead:
1. They panic-sell. It can be gut-wrenching to see your investment portfolio or the 401(k) plan that you’ve been building for years take a sudden dive. The urge to staunch the bleeding can be overwhelming—to salvage what you can and wait for the dust to settle. Ironically, this can be the single most damaging thing an investor can do.
Selling into a falling market insures that you lock in your losses. If you wait years to get back in, you may never recover. Consider that someone who stayed invested from 1980 until the end of February would have a 12% annual return, compared to someone who started at the same time, but sold after downturns and stayed out until two consecutive years of positive returns, who would have averaged a 10% return annually.
That may not sound like a huge difference, but if each investor contributed $5,000 a year, the buy-and-hold investor would have $4.3 million now; the waffler would have $2.5 million.
Instead, do this: Take the long view. If you don’t need cash right away and have a well-researched, diversified portfolio, realize that downturns ultimately are temporary. The market may sometimes feel like it could go to zero, but market history shows that rebounds can return many portfolios to the black in just a few years.
2. They go to cash and stay there. This mistake compounds the damage from panic selling. The strong rebound in stock prices that often follows a market downturn should underscore how bailing out can cost you when the market reverses direction. Returning to our hypothetical example, an investor who sold after a 30% market drop and stayed in cash would have just $430,000 at the end of 40 years, even after investing $5,000 a year.
Instead, do this: Investors who have more cash than their long-term strategy calls for because they sold during the market slide, or for any other reason, should look to close that gap and get invested. Dollar-cost averaging, a method where you buy set amounts of stock at regular intervals (say, monthly) to get back into the market gradually, can be a good way to get there. Dollar-cost averaging reduces the sensitivity of your portfolio to the luck of timing, which can make it easier for fearful investors to move out of cash, since they can avoid the worry of putting a big chunk of money into the market, only to have the sell-off resume. And if the market rebounds, they will be glad that they already put some of their money back to work, rather than having all of it on the sidelines.
3. They are overconfident and make poor choices. Many people overestimate their ability to judge when a stock is a great deal at a certain price. An example of that is “anchoring” the value of a beaten down company by the much higher price it used to trade at when it still has a lot further to fall. As this practice is known by market insiders as “trying to catch a falling knife”, it is clearly one with an ignominious history.
Overconfident investors tend to think they know better than even professional investors what’s going on in markets and can make all the right moves to avoid losses and lock in bargains. They can drive themselves to distraction and end up with a portfolio in disarray and even deeper losses. Profiting from short-term trading is a lot more difficult in practice than it seems.
Instead, do this: In times of market uncertainty, you don’t have to figure out what to do next on your own. Find a Financial Advisor you trust to go through your portfolio with you and help you understand how best to proceed, based on your time horizon and risk tolerance.
4. They dig a deeper hole trying to make up for losses or bad choices. It is common for investors to loathe the idea of selling an investment at a loss, or below the high water mark. This can cause them to hang onto losers too long because they believe those stocks will rise again and to sell winners too early because they worry those stocks will decline—what is known in behavioral finance research as the “disposition effect.” Often, investors would be better off selling stocks doing poorly in the market and holding onto stocks that are rising because they are better positioned for the current environment.
Instead, do this: Proactively take advantage of current opportunities, which can often run counter to those instincts. For example, if losses arise in a taxable investment account, “harvesting” them by selling those positions can improve long-term tax efficiency. Also, many investors are better off converting at least some of their retirement savings from a traditional IRA to a Roth IRA. Since there are tax consequences, doing a conversion when stock values are depressed could be a good move. This, again is something a Financial Advisor can help with.
5. They forget to rebalance. During a major market selloff, a portfolio’s asset allocation to equities tends to decrease substantially, as stocks sell off and bonds rally. Often shocked by the move, investors may neglect to rebalance their portfolios back into equities and, as a result, may extend the amount of time the portfolio takes to recover from market drawdown.
Instead, do this: If you’ve decided on a rebalancing plan, stick to it. Studies have shown that rebalancing tends to improve risk-adjusted returns over time, as long as it doesn’t generate excessive tax and transaction costs, by reducing portfolio sensitivity to the timing of up and down markets. It also gels with markets’ natural tendency to revert to the mean.
The corollary to buying equities to rebalance after a selloff is the need to sell them after a strong bull market moves those allocations much higher. That tends to enforce a buy-low and sell-high discipline on your investments that is systematic, rather than speculative.
Investment losses are painful, but if investors can stay focused on their goals, rather than obsessing over monthly account statements, they will likely feel better and be better off in the long run. Working with a Financial Advisor can help you steer through volatility and stick with your plan.