The first quarter of 2018 has delivered a clear reminder that the law of gravity remains in force and markets can go up as well as down. Intellectually, experienced investors know a certain amount of volatility comes with the territory and is nothing to panic about. But humans are emotional creatures, and it can be hard for us to ignore the twinges of worry that we often feel when markets reverse course.
Downturns can test investor resolve, sabotage otherwise solid plans, and just plain hurt. But experience and evidence are on the side of investors with a long-term outlook. Acting rashly is far more damaging to portfolios than maintaining rational resolve during market downturns.
Just as we prepare for any emergency by practicing how to avoid blunders, we can take steps to avoid costly mistakes when markets are in the negative.
1. Don't panic. It's easy to believe you're immune from panic when the financial sun is shining, but it's hard to avoid indulging in worry during a crisis. If you're entertaining seemingly logical excuses to bail out during a steep or sustained market downturn, it's highly likely your behavioral biases are doing the talking. Even if you only pretend to be calm, that's fine, as long as it prevents you from acting on your fears.
2. Remember the evidence. One way to ignore your self-doubts during market crises is to heed what decades of practical and academic evidence have taught us about investing: Capital markets' long-term trajectories have been upward. Thus, if you sell when markets are down, you're far more likely to lock in permanent losses than come out ahead.
3. Manage your exposure to breaking news. There's a difference between following current events versus fixating on them. In today's multitasking, multimedia world, it's easier than ever to be inundated by news. When you become mired in the minutiae, it's hard to retain your long-term perspective.
4. Revisit your carefully crafted investment plans (or make some). Even if you yearn to go by gut feel during a setback, remember: You promised yourself you wouldn't do that. When did you promise? When you planned your personalized investment portfolio, carefully allocated to various sources of expected returns, globally diversified to dampen the risks involved, and sensibly executed with low-cost funds managed in an evidence-based manner. What if you've not yet made these sorts of plans or established this kind of portfolio? Then these are actions we encourage you to take at your earliest convenience.
5. Reconsider your risk tolerance (but don't act on it just yet). When you craft a personalized investment portfolio, you also commit to accepting a measure of market risk in exchange for those expected market returns. Unfortunately, during quiet times, it's easy to overestimate how much risk you can stomach. If you discover you're miserable to the point of breaking during even modest market declines, you may need to re-think your investment plans. Start planning for prudent portfolio adjustments, preferably working with an objective advisor to help you implement them judiciously over time.
6. Double down on your risk exposure – if you're able. If, on the other hand, you discover you've got nerves of steel, market downturns can be opportunities to buy more of the depressed (low-price) holdings that fit into your long-range investment plan. You can do this with new money, or by rebalancing what you've got (selling appreciated assets to buy the underdogs). This is not for the timid! You're buying holdings other investors are fleeing in droves. But if you're able to do this and hold tight, you're especially well-positioned to make the most of the expected recovery.
7. Harvest tax losses. Depending on market conditions as well as your own circumstances, you may be able to use tax-loss harvesting to turn financial lemons into lemonade during market downturns. A successful tax-loss harvest lowers your tax bill without substantially altering or impacting your long-term investment outcomes. This action is complicated, however, so it's best done in alliance with a financial professional who is well-versed in navigating the challenges involved.
8. Talk to us. We expect that sooner or later, markets will tank again for a while, just as we also expect they'll eventually recover and continue upward. We hope today's drill will help you be better prepared for "next time." We also hope you'll be in touch if we can help. After all, there's never a bad time to receive good advice.