Last week was scary for many investors. The Dow Jones dropped 832 points, and the Nasdaq and S&P 500 indices took substantial hits. Concerns about rising interest rates and U.S. corporate debt levels spurred a sell-off among risk adverse investors that made things worse. Hopefully, you were not one of those quick to jump ship.
Hopefully, you sat back to wait for market dynamics to play out. If you had the knee-jerk reaction to sell, then you might have skipped one of the most important lessons in investing: Volatility is a cornerstone of the stock market, and it isn’t something to be afraid of.
With history as our guide, we can always expect the stock market to “crash” at some point. “Corrections” of 10 percent or more have occurred on average once each decade. They can’t be accurately predicted, but that doesn’t mean investors can’t prepare for them. If you let yourself panic every time the market falls by a few percentage points, you’re probably going to cause yourself financial harm if said panic leads you to make rash decisions.
Investors are more likely to get hurt by a market dip or correction if they take a short-sighted approach to investing. If on the other hand, you maintain a long investment horizon (five to seven years or longer) you’re more likely than not to come out ahead, provided you monitor and follow these guidelines along the way:
Diversify your portfolio. This seems like obvious advice, but there are many investors who concentrate their stock portfolio in certain industries, jurisdictions or sectors. During the global financial crisis a decade ago, investors in the S&P 500 took a 55 percent hit, and financial stocks in particular loss more than 75 percent of their value. Market crashes are often driven by a singular industry, so making sure that you are not overexposed to any one sector can reduce your losses if a crash occurs.
Rebalance your portfolio. Generally we do not advice on selling just because stock prices have gone up. But if a single stock or portfolio position becomes larger than it should be, you should rebalance back to your strategic long-term asset allocation. Trimming gains in your biggest positions can help you further diversify the portfolio as economic and capital market expectations change. Seek out opportunities that are less correlated with the stock market, but that still support your objectives and investment thesis and are in line with your risk tolerance
“Insure” your portfolio. Another tool to protect your portfolio from a market crash are options. Investment strategies that include buying “puts” can reduce downside risk. By buying a put contract, you own the right to sell your shares at a certain price in the future, thereby insuring a minimum value for your shares during the length of that option contract. The downside is if the stock doesn’t fall, you’re still out the premium you pay to buy the option, which can be substantial. Ask your advisors about these and other options to withstand the next crash.
Nobel Prize winner Richard Thaler’s research demonstrated that people have a greater emotional response to losses than to equivalent gains, a phenomenon known as “loss aversion.” So, that strong urge to sell comes as no surprise when investors start seeing stock prices fall.
Thankfully, most investors will usually wait for market dynamics to play out and stick to their strategic asset allocation. A good way to appease fears is to look at where the portfolio started and where it is now. For long-term investors, this usually provides a shower of confidence and much welcomed perspective.