(Sam Swenson, CFA, CPA)
With screens flashing red everywhere we look, it’s been hard to ignore the steep drop in financial markets we’ve seen in the first half of the year. With that said, out of past downturns have emerged millionaires, and it’s important to remember how people have historically dealt with similar scenarios.
Here, we’ll look at three winning strategies – and three losing ones – when it comes to managing a stock market pullback.
3 winning strategies
- Staying the course. Past data show that those who weather volatile stock markets generally recover quite well, often ending up with more than they did before the downturn began. Selling stocks during a downturn may make you feel better in the moment, but it’s also likely to cost you in the long run. This is particularly true when it comes to index fund investmentswhich have continued to make new highs even despite major global and domestic shocks.
- Reinvesting dividends and capital gains. If you receive a dividend or capital gain distribution after prices have fallen, and you’ve set them to reinvest, you’ll buy more shares upon receipt of the distribution. Essentially, reinvesting your dividends and capital gains forces you to auto-buy when stocks are on sale, thus lowering your average cost for the position.
- Tax-managing your portfolio. Strategically exiting certain positions, like an overly concentrated stock position (say, one stock that takes up 75% of your portfolio) and immediately deploying the proceeds into broad market index funds can be a smart move. First, you’ll attain greater diversification by choosing a basket of stocks as opposed to only one, and second, you’ll limit your tax bill by exiting the position when it has only limited gains. Again, this all assumes you’re willing to invest the new funds into a more diversified portfolio.
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3 losing strategies
- Selling everything in a panic. Selling might make the immediate pain of losing stop, but you’ll be hurting yourself in the long run by taking yourself out of the market. Here at the Fool, we’re passionate about buying and holding great companies that are poised to do well over long horizons; most of the best investments are designed to deliver over a period of years, not days or months. As a not-so-pleasant add-on, you may or may not lock in a huge tax bill that would be due next April.
- Stopping your auto-contributions. If you’ve enrolled in a 401 (k) arrangement to deposit 10% of your check into your company’s retirement plan, stopping contributions will do little to help your future retirement savings. In fact, it’s a great time to increase your contributions if you can, and to take advantage of bargain prices in the market.
- Trying to predict what will happen next. The reality of the matter is that nobody knows precisely what will happen next when it comes to the stock market’s performance, but we do have a wealth of data that shows a very clear uptrend in broad markets over the past 100 years. Using that as a guide, it’s best to ignore the short-term noise and focus on what’s most likely to happen over the next several decades.
- A chart of the past 11 years is below, with Vanguard’s S&P 500 Index Fund (NYSEMKT: VOO) used as an example.
Control what you can
When the market heads south, it’s rarely ever a good strategy to act on the negative emotions you may be feeling. Instead, focus on what you can control: Continue investing on a periodic basis, avoid selling unless it’s for tax optimization, and don’t get caught up in trying to predict the market’s next short-term move.
Certainly, if you feel you’ve taken on more risk than you can bear, use that as a guide when it comes to updating your financial plan. Make sure you’ve got a strong sense of your personal risk tolerance, and build in a sizable cash cushion to deal with moments like these. Whatever your choice, know that all money decisions are entirely personal, and often encompass the non-financial as much as the financial.
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