Stock market corrections — defined by declines between 10% and 20% in major indexes — are unavoidable in the stock market. In fact, they tend to happen at least once every two years on average. If you're an investor, you'll save yourself some stress by coming to terms with that fact. The one thing you definitely want to avoid doing is panic selling. Not only can it be costly at the moment, but it can also cost you lots of future money too.
Let time work its magic
One of the greatest concepts in investing is compound interest. Albert Einstein even allegedly called it the “eighth wonder of the world.” Compound interest happens when the money you earn from your investments begins to earn money itself. But for compound interest to really work its magic, it needs time. If you made a one-time $10,000 investment into an asset that returned 10% annually, you would have accumulated $108,000 in 25 years.
When things get rocky in the stock market and prices begin to drop, some people panic and sell out of their holdings, because they're afraid of losing more money. For long-term investors, though, panic selling is one of the last things you want to do, because it takes away the power of compound interest.
Imagine that, for the past 10 years, you've been contributing $6,000 annually to a Roth IRA (the maximum for people under 50 years old), and those holdings returned 10% annually. In those 10 years, you would have accumulated over $105,000, even though you only personally contributed $60,000. Regardless of what's happening in the market, cashing out that $105,000 would likely be a mistake.
If you kept your contributions going for another 10 years, you would invest an additional $60,000, but your total account value would be over $378,000 at the end of the second decade (assuming the same 10% rate of return). Had you pulled out of the market, you would've interrupted the powerful effect compound interest has on your portfolio.
Even if you sold out of your investments for just one year, say, year 16, before reinvesting it for the remainder of the decade, your holdings would total just $346,000. In other words, even while still making all of the annual $6,000 contributions, that one year off reduced your return by over $30,000.
Don't forget about Uncle Sam
Another reason you want to avoid panic selling during stock market corrections or downturns is because it could be costlier than you imagine once you factor in the tax consequences. For a standard brokerage account, if you've held investments for less than one year, the proceeds from the sale are taxed at your ordinary income tax rate. For single filers in 2022, the brackets are:
$0 to $10,275
$10,275 to $41,775
$41,775 to $89,075
$89,075 to $170,050
$170,050 to $215,950
$215,950 to $539,900
$539,900 or more
If you've held the investments for one year or longer, you benefit from the capital gains rate:
Long-Term Capital Gains Tax Rate
$0 to $40,400
$40,401 to $445,850
$445,851 or more
Even though the capital gains rate is more favorable than your regular income tax rate, it's still money you'll owe. If you sell in response to short-term volatility, you'll need to consider how much it's going to cost you in taxes too. Paying 15% on $100,000 in capital gains is not only $15,000 you'll owe with your next tax bill, but it's also $15,000 you won't have the chance to earn interest on.
Keep your eyes on the prize
Long-term investors should be focused on just that: the long term. If your portfolio is taking hits because of a stock market correction, flip your mindset and consider it an opportunity instead of something to panic over. Warren Buffett put it all into perspective when he said, “be fearful when others are greedy, and greedy when others are fearful.” Your long-term goals shouldn't change because of short-term trends in the market. Stay the course and keep your eyes on the prize.
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