Stocks can drop for a variety of reasons, sometimes known (e.g. a terrorist attack), and in many cases for no discernable reasons. Here are some examples of why investors sell once markets start dropping (for whatever the initial reason was), with selling begetting selling:
- Stocks go down, someone who has taken on excess leverage gets a margin call and are forced to sell.
- A stock breaches a technical level to the downside, triggering investors (whether human or ‘machines’) to sell based purely on short-term price action.
- Stocks start declining, an investor has been hearing about doomsday scenarios for months (if not years), and in a panic sells based on emotions and the need to ‘do something’.
- A mutual fund has a rule that if a stock drops 10%, they must sell – regardless of fundamentals. Nothing has changed with the stock, other than price, which was driven by things that have nothing to do with its business and are transitory in nature.
None of these things have anything to do with you or your financial plan, your intention to take a trip in retirement in 2 years, the quality of your investment portfolio, the dividends your companies pay, etc. So when should you sell?
- When the fundamentals of your stock have changed materially – either for the better (valuation has become very rich, so you sell on strength), or something very basic has changed – like their products/services are becoming obsolete (think Blockbuster vs. Netflix) and the like.
- When you need the cash in 18 – 36 months (not hours or days…months), in which case convert stocks to fixed income (maturities matching your time horizon) regardless of whether we are in a bull market (you can take advantage of strength), bear market, or sideways market.
- For tax mitigation purposes.
- If the position has become too large a part of your portfolio (risk control purposes) – then sell the appropriate amount to bring the position size in line.
As you can see, there is no overlap between why stocks go down and when you should sell.To be sure, your financial life is your financial life, your financial plan is your financial plan, your portfolio is your portfolio…. If you have created and maintained a sound financial plan, get the basics right (proper asset allocation, broad diversification, etc.) then at worst other people’s need to sell – and the broad market decline that ensues - has zero impact on you. At best, you can take advantage of it through buying high-quality companies (assuming you have some ‘dry gun powder’) at lower prices from someone who is selling because they made the mistake of using excess leverage, etc. The stock market is simply a means for transferring wealth from the impatient and imprudent to the patient and prudent, so be the latter, not the former.
How to Survive a Bear Market
Bear markets (declines of 20%+) do happen on average every 4 – 5 years, only no one can predict with accuracy when and why it will happen. It is easy to prognosticate the decline every month for years, then when it happens say ‘I told you so’ but in reality, you would likely have given up far more in gains than lost in the correction by trying to anticipate it to begin with. Recent bear markets have stemmed from things like a pandemic (unpredictable), a terrorist event (unpredictable), wars (unpredictable), etc. So how do you protect yourself against the next one (since timing it is not possible – very smart and well-intentioned people have been predicting the next recession and associated bear market for the last 18 – 24 months, meanwhile stocks keep hitting record highs)?
- Stay still. Very still. When it comes to stock ownership, often inaction is your best course of action. If you are properly allocated to short duration assets for near-term needs and long duration assets for long-term needs, then there is nothing you need to do. This is why we constantly ask our clients what their cash needs are for the next 12 - 18 months, and put that amount in short-term fixed income.
- Own dividend paying stocks. Nearly half of all the S&P 500 returns have come from dividends over the last 40 years. When you own high-quality dividend paying stocks, you can sleep at night knowing that at least about half your profits are secure. Having a steady source of incoming cash also lessens your likelihood of selling your stocks at the wrong time. During bear markets, dividend paying stocks tend to go down less than the overall market/than growth stocks with high P/E ratios. To the extent you don’t need the income in the near term, the reinvestment of said dividends leads to more share ownership and potential higher future income – plus capital appreciation – once stocks recover. Ideally you have planned such that you can take advantage of lower prices by reinvesting dividends during bear markets, but if need be you can work with your financial advisor to turn off dividend reinvesting to let cash pile up, even if only for the purpose of keeping you from taking detrimental action otherwise.
- Engage in things in life that take your mind off of what may be (but shouldn’t be) stress inducing day to day stock price movements. Go workout, start a new hobby, call a friend, meditate. Things that are positive for you and occupy your time will make you less inclined to track day to day market vacillations – and generally make you a happier person. Remember, your money is supposed to work for you, not the other way around.
- Review statistics around how long bear markets typically last – and compare this with your actual investment time horizon. The average bear market lasts just over a year (even though it may seem like a lifetime). I’ve had clients who are 10 years from retirement (with a need for their money to work for them another 20+ years beyond their retirement date) express fear over near-term stock price declines – even though in reality by reinvesting dividends they will be financially better off in 10+ years by virtue of stock price declines today. Be very realistic about your true investing time horizon. Remember, a stock yielding 4% today can have an effective yield (income divided by original purchase price) of double digits in 10 years between reinvested dividends and annual dividend increases.
- Review facts around how attempting to time the market statistically will likely make you poorer than if you maintain a disciplined approach. There are countless studies showing empirically that the probability of attempting to time the market leading to far worse returns than holding a steady course is high – even for those who dedicate their lives to timing markets, let alone those who have professions outside of money management.
Life is complicated and stressful enough as it is. Don’t make it more so unnecessarily by taking undo risks or reacting emotionally – sans a plan – to things both outside your control and irrelevant to you and your specific financial circumstances. People who succeed in investing (and in many aspects of life) share common traits, and being a genius is rarely one of them. Rather, they have certain temperaments, or characteristics, like patience, planning, discipline, independent thinking….these will allow you to survive any market condition and live a richer, fulfilling life.