Investors make various blunders that might cost them in the long run, whether it’s panic selling, sheltering in cash, or trading hastily during tumultuous markets. Learn to recognize and prevent the most prevalent harmful habits.
As distressing as market sell-offs might be, one aspect always strikes me as familiar: the attempt to persuade investors to avoid the significant financial blunders that can result from short-term thinking during a sell-off.
Here are some of the most common investing blunders, along with my recommendations on what to do instead:
1. They sell in a panic. Seeing your investment portfolio or 401(k) plan, which you’ve been building for years, take a rapid tumble may be heartbreaking. The desire to stop the bleeding—to save what you can and wait for the dust to settle—may be overpowering. Surprisingly, this might be the most harmful thing an investor can do.
Selling into a declining market ensures that your losses are locked in. You may never be able to get back in if you wait years. Consider this: Someone who invested from 1980 through the end of February would have earned a 12 percent annual return, compared to someone who joined at the same time but sold between downturns and remained out until two years of positive returns, earning a 10 percent annual return.
Although this may not seem like a significant difference, if each investor contributed $5,000 each year, the buy-and-hold investor would now have $2.6 million, while the waffler would have $1.4 million.
Instead, consider the big picture. If you don’t want cash right immediately and have a well-diversified, well-researched portfolio, remember that downturns are only transitory. The market may seem to be heading for zero at times, but market history demonstrates that recoveries can bring many portfolios back into the black in a matter of years.
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2. They go to the bank and remain there for a long time. This blunder adds to the harm caused by panic selling. The sharp rise in stock prices that often follows a market collapse should serve as a reminder of how much bailing out might cost you when the market turns around. Returning to our hypothetical example, even after investing $5,000 a year for 40 years, an investor who sold after a 30% market loss and remained in cash would have just $412,000 at the end of 40 years.
Instead, investors who have more capital than their long-term plan requires, whether because they sold during the market downturn or for any other reason, should aim to reduce the gap and get back into the market. Dollar-cost averaging, a strategy of gradually re-entering the market by purchasing specified quantities of stock at regular intervals (say, monthly), may be an excellent approach to get there. Dollar-cost averaging decreases your portfolio’s susceptibility to luck of timing, making it simpler for scared investors to exit cash since they won’t have to worry about placing a large quantity of money into the market just to see the sell-off restart. And, if the market recovers, they’ll be pleased that they put part of their money to work rather than leaving it completely on the sidelines.
3. They are self-assured and make terrible decisions. Many individuals overestimate their ability to determine whether or not a stock is a good buy at a given price. An example of this is “anchoring” a beaten-down company’s value by the much higher price it used to trade at while it still has a long way to go. Market insiders refer to this technique as “trying to catch a falling knife,” and it has a dreadful track record.
Overconfident investors believe they know more about the markets than even experienced investors and can make all the necessary actions to prevent losses and lock in bargains. They may easily get distracted, resulting in a jumbled portfolio and even greater losses. In actuality, profiting from short-term trading is far more difficult than it seems.
Instead, try this: You don’t have to figure out what to do next on your own in times of market volatility. Find a Financial Advisor you can trust to go through your portfolio with you and advise you on the best course of action depending on your time horizon and risk tolerance.
4. They dig a deeper hole to compensate for losses or poor decisions. The thought of selling an investment at a loss or below the high water mark is frowned upon by many investors. This may lead people to hold on to losers for too long in the hope that they will rise again, and sell winners too soon in the hope that they would decline—a phenomenon called in behavioral finance as the “disposition effect.” Investors are often better off selling equities that are underperforming the market and sticking onto stocks that are outperforming the market because they are better positioned for the present environment.
Rather, try this: Take advantage of existing possibilities before they pass you by, which may go against your inclinations. If losses occur in a taxable investment account, for example, “harvesting” those losses by selling such holdings may help with long-term tax planning. In addition, many investors would benefit from converting at least portion of their regular IRA holdings to a Roth IRA. Because there are tax implications, converting when stock prices are low may be a wise decision. Again, a Financial Advisor can assist you with this.
5. They overlook the need of rebalancing. During a big market downturn, a portfolio’s asset allocation to equities tends to plummet as stocks fall and bonds rise. Investors may be so taken aback by the move that they fail to rebalance their portfolios back into stocks, extending the time it takes for the portfolio to recover from market decline.
Instead, do the following: If you’ve made a decision to rebalance your portfolio, stick to it. Rebalancing has been demonstrated to boost risk-adjusted returns over time, as long as it does not result in excessive tax and transaction costs, by lowering portfolio sensitivity to market timing. It also fits with the natural propensity of markets to return to the mean.
The need to sell stocks after a strong bull market raises such allocations considerably higher is a consequence of purchasing equities to rebalance after a selloff. This tends to impose a methodical, rather than speculative, buy-low, sell-high discipline on your assets.
Losses in investments are unpleasant, but if investors can keep focused on their objectives rather than worrying on monthly account statements, they will likely feel better and be better off in the long term. Working with a Financial Advisor may help you navigate through the ups and downs of life and stay on track with your goals.