Stock investors are coming off the worst week in two years, leading to the inevitable question: What should I do when the market drops? The answer for long-term investors is clear: nothing.
Still, when you hear about big point and percentage losses, especially as the second longest bull market on record tempts some to call the market top, it’s hard not to feel butterflies. Although some investors may be tempted to sell, they do so at their own peril. Market timing requires you to make two precise decisions: when to sell and then when to buy back in, something that is nearly impossible. After all, even if you sell and manage to steer clear of the bear by staying in cash, you will not be able to reinvest dividends and fixed-income payments at the bottom and you are likely to miss the eventual market recovery.
In fact, data from Dalbar confirm that when investors react, they generally make the wrong decision, which explains why the average investor has earned half of what they would have earned by buying and holding an S&P index fund.
The best way to avoid falling into the trap of letting your emotions dictate your investment decisions is to remember that you are a long-term investor and you do not have all of your eggs in one basket. Try to adhere to a diversified portfolio strategy, based on your goals, risk tolerance and time horizon and do not be reactive to short-term market conditions, because over the long term, this strategy works. It’s not easy to do, but sometimes the best action is NO ACTION.
If you are really freaked out about the movement in your portfolio, perhaps you came into this period with too much risk. If that’s the case, you may need to readjust your allocation. If you do make changes, be careful NOT to jump back into those riskier holdings after markets stabilize.
And if you know that you need to access cash from your investments within the next year, perhaps for a house down payment, a car purchase or a tuition bill, that money should not be at risk at all, so go ahead and get it out of the market.
If you have cash that is on the sidelines and are nervous putting it to work as a lump sum, you should take heart in research from Vanguard, which shows that two-thirds of the time, investing a windfall immediately yields better returns than putting smaller, fixed dollars to work at regular intervals.
But, if you are the kind of investor who is less concerned with the probability of earning and more worried about losing a big chunk of money immediately, you may want to stick to dollar cost averaging. Vanguard notes “risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline.”