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Sometimes, happy financial surprises can happen.
Many growth stocks have suffered amid a recent sell-off. The ARK Innovation ETF, one of the more prominent funds run by investor Cathie Wood, has lost over half of its value over the last year.
Such a decline can rattle even the most seasoned investors. However, knowing the three things not to do can help stockholders cope with darker times.
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1. Lose control of one’s emotions
Investing psychology often receives little attention in the investment community. This often leads to problems since investors often make buy and sell decisions purely on emotion, a trait that can work against stockholders.
In times of prosperity, success can make investors euphoric. However, those positive emotions can give way to depression when stock market gyrations turn strongly negative. Such reactions can prompt investors to buy when stock prices are high and sell when stocks have become inexpensive, making it difficult to earn positive returns.
Another emotion-related issue stems from not knowing one’s ability to deal with risk. Risk-tolerant investors may take the volatility in stride, while risk-averse investors may find themselves unable to sleep at night.
The good news is both types of stockholders can cope with market crashes if they align their investment choices with their tolerance for risk. Risk-tolerant investors might want to reconsider the investment case for their various positions. If the investment case for their stocks remains intact, they should probably ride out the volatility, only selling if the original investment thesis no longer applies.
Risk-averse investors should consider managed investment products such as ETFs or mutual funds consistent with their risk tolerance. This strategy provides them with a sufficiently diversified set of stocks that can minimize the impact of large-percentage moves in the market.
2. Give up on stock investing
Risk management is also essential since following a market crash, some investors may want to give up investing and exit the stock market entirely. However, stockholders should remember that dealing with a stock market crash is inevitable if one invests in the market long enough, and exiting the market during such a time could become a grave mistake.
The best reason for riding out market crashes is the long-term track record of the market. The average annualized return of the S&P 500 since 1926 is over 10% including dividend income. This nearly 100-year track record includes challenging periods for the market such as the Great Depression in the 1930s, economic turmoil during the 1970s, and the 2008 financial crisis.
During the Great Depression, a 44% drop in the S&P 500 in 1931 gave way to a 57% gain two years later. More recently, a 37% decline in the index in 2008 turned into a 27% surge in 2009 and gains in every year thereafter until it experienced a 4% drop in 2018. This type of track record shows that even in the worst of times, it pays for investors to hold steady following significant market swoons.
3. Refrain from buying stocks after a crash
Finally, investors who have cash during such times should consider buying. Admittedly, when stock prices fall, investors tend to expect further drops and do not want to buy for that reason.
Nonetheless, as mentioned before, such declines tend to lead to gains once the selling stops. Also, investors often fail to see that stocks have gone on sale during such times. Interestingly, when a retail store advertises discounted prices on merchandise, it tends to attract more buyers. Yet, lower stock prices often have the opposite effect on investors, a reaction that can lead to buyers missing opportunities.
Again, if “shopping” for individual stocks instead of ETFs or mutual funds, buyers should perform due diligence to confirm that the investment case for the underlying business remains intact. But assuming the underlying business or businesses remains solid, a strategy of buying at a discount can pay off after a market recovery.
Coping with a market crash
Market crashes can understandably concern shareholders. However, investors can turn this event to their advantage by staying invested and choosing stocks, ETFs, or mutual funds that are appropriate to their tolerance for risk. These investors can not only ride out market crashes but put money to work in stocks, ETFs, and mutual funds at a discounted price. This approach can help boost returns in the long run.
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Will Healy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
