Until this past week, the stock market looked rock solid. The S&P 500 was near an all-time high and the Dow Jones Industrial Average had just broken through the 35,000 mark for the first time in history.
Yet some industries — namely smaller tech stocks, growth stocks, and renewable energy stocks — were downright crashing. Some notable names have fallen over 50% from their highs, or worse.
Whether your portfolio is bleeding red or you're looking for strategies to navigate a potential downturn, you've come to the right place. Here are three tools you can use to keep your composure and make the best decisions during a stock market sell-off.
1. Invest in securities you understand
It sounds simple but understanding the businesses you own can do wonders for your mental health during a stock sell-off. Anyone can get lucky with a speculative play over the short term. But what happens when the value of that investment gets cut in half during a downturn?
The temptation to sell a business is much easier if you don't understand what it does or why it's valuable. At The Motley Fool, we want to help you understand quality businesses and avoid bad ones. If the whole market is selling off, there's a good chance that strong businesses are going down, too. However, if a stock's price is going down substantially more than the market, a deeper analysis is worth a look.
2. Maintain a long-term perspective
Maintaining a long-term horizon is a timeless lesson that can help investors navigate short-term randomness.
After the shock of the COVID-19 sell-off last spring, many excellent companies plummeted due to short- to mid-term challenges. Disney (NYSE: DIS) is an excellent example of a great company that reached a multiyear low before surging to a new all-time high in 2020. Aside from the added value of Disney+, investors realized that although the company's theme park and movie theater revenue was nosediving, it had nothing to do with the business itself, but rather, a pandemic that was outside of its control.
A similar phenomenon is happening right now as many companies struggle to navigate everything from supply chain issues to lumber shortages and inflation. These challenges affect some businesses more than others, but by and large, they are short-term problems that shouldn't alter a company's performance over the long term.
3. Don't use margin
Buying stocks or trading options on margin is a form of leverage. Like anything in business, leverage increases the degree of gain or pain.
Brokerages will offer margin to their clients at different interest rates and in different quantities depending on a slew of factors like investing experience, portfolio size, etc. No matter the size or interest rate, being on margin is one of the worst things you can do during a stock sell-off.
When stocks are going down in a cash-supported account, long-term investors can take solace knowing that they own shares in real companies. Margin doesn't work that way because the investor doesn't really own shares, but rather has borrowed money to buy shares or trade options.
If the investor doesn't have enough cash to cover a decline in the value of their securities, the broker may issue what's called a margin call. A margin call means that the client's equity has fallen below the required levels. There are two basic choices: Sell securities or funnel more cash into the account.
Unfortunately, margin calls lead many investors to forcibly sell during market downturns because they lack the cash to cover their account's deficit.
Similar to a company that has too much debt, and therefore an unhealthy balance sheet, relying heavily on margin is a sign of financial insecurity. Although it can be tempting to use margin and inflate gains on the upside, the downside risk rarely makes it worth it. Peter Lynch, my personal favorite investor of all time, illustrated the risks of margin well when he said, “When you have a family, and a house, and the market is going down, and you're on margin, it's probably too much pressure for you to do the right research and the right kind of thinking to make good decisions.”
Keeping your composure
Each of the three points in our discussion shares a common denominator: level-headed thinking. Keeping a clear mind and staying mentally sharp when your net worth is plummeting is not an easy thing to do. Investing in securities you understand, maintaining a long-term time horizon, and avoiding margin are three tools you can use to stay focused during chaotic times.
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Daniel Foelber has the following options: long January 2023 $125 calls on Walt Disney, long October 2021 $170 calls on Walt Disney, and short January 2023 $130 calls on Walt Disney. The Motley Fool owns shares of and recommends Walt Disney. The Motley Fool has a disclosure policy.