Don’t trust your gut, at least when it comes to falling — or surging — stock prices.
Your natural response to a massive sell-off or a big gain in stocks may be to “do something,” especially if much of your wealth, and ability to comfortably retire, is tied to the returns of various investments, including stocks.
It’s easy to focus on the volatility
On Dec. 19, 2018, the Federal Open Market Committee voted to raise the target range for the federal funds rate by 0.25%. This happened during a multiple-day decline for the Dow Jones industrial average.
Then on Dec. 26, 2018, the Dow surged more than 1,000 points — its largest increase in a day. Ever.
Finally, on Jan. 4, Federal Reserve Chair Jerome Powell spoke at the American Economic Association and Allied Social Science Association 2019 Annual Meeting. Powell reassured markets that the Fed’s policy is flexible and that he won’t resign if Trump asked him to. The speech sent the Dow up more than 600 points.
These few weeks of events sent the market pretty much back to where it was at on Dec. 19, 2018, making the lesson clear: one day, one week or even one month doesn’t usually shape the long-term market.
Responding to market volatility by selling stocks is hardly ever a good idea. Here’s why.
Investors too often act when they shouldn’t
When it comes to groceries, you always want to buy products when they’re on sale. But investors have a nasty habit of buying high and selling low.
“Fear and greed drive the stock market,” says Roger Wohlner, a financial writer, advisor and owner of The Chicago Financial Planner. “All too often investing decisions to buy or sell are made out of emotion rather than research and logic.”
For instance, the Dow Jones industrial average (DJIA) sunk to 21,792.20 on Christmas Eve 2018 after a long slide from 25,779.57 at the beginning of the month. Two days later, though, the Dow climbed more than 1,000 points. If selling on Christmas Eve was your gut instinct, that probably was the wrong move.
Another example is when the S&P 500 closed 2008 at 903.25. That index ended 2018 at 2,506.85 – which results in a 10-year annualized return of more than 10%, according to S&P Dow Jones Indices. If you didn’t get back in at the right time – and sold prior to 2008 – you missed out on seeing the market reach uncharted territory.
It’s easy to get psyched out by the news and make bad bets. Brandon Renfro, Ph.D., a fee-only financial advisor and assistant professor of finance at East Texas Baptist University, says the feeling is natural. But that kind of emotional investing can be your undoing.
Losing is painful, but not investing is even more so
Reacting to market ups and downs contradicts what financial planners will tell you to do. That is that stock prices will rise and fall, but they’ll mostly gain over the long haul. The only way to profit off long-term returns is to keep your money working for you, even when the sky looks like it’s falling.
“If your horizon is 10, 20 or 30 years away from when you plan on using that investment,” says Larry Ludwig, principal at Ludwig Media and former founder of Investor Junkie, “odds are the stock market will be higher than it is today. This, of course, assumes indexing and not individual stocks.”
Part of the problem, according to William Bernstein of Efficient Frontier Advisors, is that many investors overestimate how much of a loss they’re willing to endure.
He has an illustrative graphic in his book, “Rational Expectations,” that shows people are more apt to trash their carefully crafted financial plan as losses mount. It just doesn’t feel good to see the value of your accounts get smaller. But pulling your money out during a short-term dip instead of buying more is usually the wrong move.
What to do when the going gets tough
The simple answer is to do nothing. Maybe turn off the television, silence your phone and go for a walk. Avoid checking your account balance for a while.
Presumably, you’ve allocated a certain percentage of your assets into stocks for a reason, and that reason shouldn’t change because of a series of short-term drops. Talk to investors who sold at the market bottom in March 2009 and missed out on the subsequent recovery. You don’t want to repeat their mistakes.
Stocks are riskier than bonds, which are riskier than money market accounts, so you should expect bad things to happen now and then.
That said, doing nothing is hard. We’re human, and humans get nervous when green numbers turn into red ones. You might think it’s unrealistic to expect yourself to do nothing.
If you’re the type of investor with an itchy trigger finger, you may have more risk in your portfolio than you’re comfortable holding. Consider shifting into an all-in-one balance fund — perhaps one that holds a mix of stocks, bonds and some cash. The same goes if you’re planning to use the funds soon.
“If your investment horizon is less than five years, you should start looking to capture your gains and decrease your allocation to stocks,” says Ludwig.
Although every investment in the market has risk, target-date funds may help you diversify your portfolio based on your goals and keep you from buying and selling too often.
“Target date funds can offer a solid tool for investors who are not comfortable with allocating their own assets,” says Wohlner. “These funds are professionally managed and maintain an allocation that gets more conservative as the target date approaches.”
Time is on your side
If you’re investing for the distant future, the regular ups and downs of the stock market, no matter how big, likely won’t have a significant impact on your ultimate goal. So whether or not you pay attention to the news, your best bet is to continue investing the same amount every month.
This strategy, called dollar-cost averaging, can help reduce your risks in the long run and weather any short-term storms that come your way.
“Dollar-cost averaging separates your investment decisions from your emotions,” says Renfro. “When the market dips, dollar-cost averaging will cause you to buy more shares at the now lower prices. In that way, a market decline can be good for you if you are making contributions.”