Downturns in the financial markets are an uncomfortable part of investing. It’s best to take steps to plan ahead of a market drop, whatever you do while a sale is also crucial. For stock investors in particular, it is unrealistic to avoid losses completely. But individuals sometimes make decisions that cause preventable financial losses. Here are three ways to reduce the risk of incurring unnecessary, self-inflicted losses in a down market.
Single shares ≠ the stock market
You’ve heard it before: past performance is not indicative of future results. It’s not only legal – it’s true – and the chart below shows why. this point. After years of strong performance…
…newly public companies as well as seasoned stocks experienced stunning withdrawals. Compare these withdrawals to the Russell 3000 and suddenly the stock market doesn’t seem that bad.¹
For single stocks, deductions like this are not uncommon. According to JP Morgan, between 1980 – 2020, about 45% of the stocks that were ever in the Russell 3000 fell 70% or more from a previous high and never recovered. Almost a coin toss.
Make no mistake, investing in one company (perhaps from employer stock options) can potentially yield massive gains, far beyond a diversified index. The issue is when investors don’t properly size their risk, understand their exposure or know when to take profits.
Checking your accounts can do more harm than good
One way investors suffer unnecessary losses is by checking their portfolio during market downturns. To illustrate, the chart below plots the one-year total return for the S&P 500. The purple line shows daily gains and losses while the orange line reports monthly.
Both have the same net result.
But if you check your account every day, you would a very more ups and downs to deal with. Wild swings in the market will stress you out at best, and at worst, prompt you to make rash investment choices that can cause self-imposed losses.
So if you’re not going to make a change, what’s the point of looking? If there is a reason to trade, make sure that recency bias does not influence the decision.
Chase the market
It can be tempting to make changes to your portfolio after recent events. Looking at various stock indexes for company size and factors, there is little correlation between the best or worst performers over the past month or year versus longer time periods. In fact, recently the outcome has been reversed.
The one-month returns from small-cap, high-dividend and defensive sectors and value are particularly astounding. Yet these indices are performing the worst for seven years. Does this mean you shouldn’t have investments with these characteristics in your portfolio? No! This simply shows the importance of diversification. Markets are cyclical.
When you look at your account daily, it’s tempting to sell the losers and ride the winners. This can have lasting implications. These charts also highlight the downside of tax loss harvesting. Crop losses for tax purposes only can have wider implications due to the wash sale rules.
If you sell an investment for a loss, you cannot buy back the position (or one that is substantially similar) for 30 days. So you will either buy something you don’t like that much or stay in cash. The market can move significantly during this time – four indices above have risen more than 10% in a month.
Nor is this an anomaly. According to Bespoke Investment Group, the S&P 500 has returned an average of 15.2% in the first month of a bull market since 1928. Over the first 3 months, the average profit increases to 31.6%. What the market will do to get out of the 2022 bear market is anyone’s guess, but historically markets move quickly, and the best days in the market often fall within a week or two of the worst days.
Silver edge! Market shifts can bring opportunities
Changing market conditions may not be everyone bad news Rising interest rates have been very bad news for stocks, bonds and home buyers. But for cash-strapped individuals, it’s a big win. One-year Treasuries now yield 4.75% … versus .17% a year ago (November 2021). That’s a 2,700% increase! Investors can create a Treasury ladder or just buy longer durations to lock in the return.
Even high-yield savings accounts give a decent return on cash. There’s no reason to park a lot of cash in a 0% checking account that earns no interest when you can enjoy a safe 3% APY in the right savings account.
However, do not suggest that individuals dump their portfolio and buy treasuries! But for some investors, yields are attractive enough where Treasuries should be part of the conversation when considering the allocation for a new cash investment.
It also highlights the nuances in investing and why few things are black and white. Not checking your account daily doesn’t mean you never check. And a passive buy-and-hold strategy should not ignore rebalancing needs, the right tax-loss harvesting opportunity, or periodic fund evaluations.
In down markets, there is a tendency for people to want to act. To do something to stop the losses. Acting on this urge often (though not always!) turns out to be an unwise decision. It is also perhaps the most common way that investors who manage their own portfolio suffer preventable financial losses.
¹ Total return percentage down high, Russell 3000 withdrawal about -22% through 11/3/2022. The Russell 3000 represents about 97% of the US stock market.