In a falling market, should you cut your losses or dig deeper?

But for the past few weeks, the gang seems to have dissolved.

And it’s not just Mr. Pathak and his group of friends. As stock markets around the world have crashed in recent weeks, depleting investors of billions of rupees, investors and so-called “experts” have remained silent.

Everyone seems to know exactly what to do when the markets are booming. But when markets fall, investors often engage in panic selling, hide in cash, or end up trading frantically.

They make several mistakes that can harm them in the long run.

Many experts list things to be prepared for when the stock market crashes, but what should investors do after that? In a falling market, should you sit back and do nothing, cut your losses, or add more stocks? Read on to find out more…

Investment time horizon

Choosing the right stocks is not a simple task. But the investment time horizon is just as important.

One of the biggest mistakes an investor can make is not aligning the timing of their goals with their stock investment.

Before talking about what an investor should do in a falling market, it is essential that one first understands the importance of the time horizon.

The investment time horizon refers to the length of time an investment will be held before the money is needed. Time horizons can help decide the type of stocks you choose to invest in your portfolio.

As the time horizon lengthens, an investor may choose to increase the risk of their portfolio. If the stock market falls like in the current scenario, a longer time horizon gives the portfolio more time to recover.

Time horizons can be subjective depending on the needs and objectives of investors, but we can categorize them into three periods: short term, medium term and long term.

The short-term horizon is less than three years. When markets crash, this timeframe may be too short for a portfolio exposed to high-risk stocks to recover.

The medium-term period is between three and seven years. With this time horizon, an investor can hold riskier stocks and allow their portfolio to grow without being overexposed to risk.

Long-term goals are generally longer than seven years. Over such a long period, an investor could remain invested in high-growth stocks for a higher potential return.

Even in a sustained bear market, the investor would have enough time to weather the storm and hold on to their portfolio.

And like everything in markets, time horizons are also dynamic and constantly changing.

An investor’s time horizon may change with age, new goals or a change in financial circumstances, etc. It is even possible to have several time horizons at the same time.

This could be an investor saving for retirement while saving to pay for their daughter’s school fees or to buy a second home.

Therefore, the time horizon is the main element on the basis of which one can determine whether to sell existing investments or add to the portfolio in a falling market.

Reduce your losses

In a falling market, especially when the market is heading for a major correction, investors should remember the most important rule: Cut your short-term losses.

No investor wants to sell at a loss. Accepting failure is painful and difficult. But to become a successful investor, you need to put your ego aside, suffer a small loss, and be fit enough, both financially and mentally, to invest again.

Reducing casualties quickly saves you from taking a devastating fall too steep to recover from.

And it’s not just us who say it. Consider this…

Suppose you buy a stock at 100 and it drops by 10% to 90 during a market drop. You quickly cut your loss and move on. Now, to recoup that loss, you need to make an 11.2% gain on your next purchase with your remaining capital, which shouldn’t be hard to do.

What if you don’t sell? What happens if the market decline continues and your stock falls to 50?

To recover a 50% loss, you need a 100% gain. How many stocks do you expect to double in price?

This does not mean that you should sell all of your investments when the market is down. Such a decision can lead to the loss of potential gains when the market rebounds.

Instead, scan your portfolio for risky, low-quality stocks with a history of volatility or a new business model and sell those stocks to reduce risk.

It’s common for investors to hang on to losers for too long because they think those stocks will go up.

And that’s not really unusual. Just as people have favorite watches or shoes, some investors have favorite stocks they don’t want to give up even if it continues to erode capital from their portfolio.

Investors are better off selling stocks that are doing poorly in the market and holding stocks that are rising because they are better positioned for the current environment.

Accounting for losses in these weak stocks would also be a good opportunity from a tax perspective and could be used to offset future gains to improve long-term tax efficiency.

Keep Calm and Hold On

Long-term investors know that the market and the economy will eventually recover and rebound.

Keeping stable investments in established companies can pay off if you can stay put until the market picks up.

During the financial crisis of 2008 or the recent pandemic of 2020, the market crashed and many investors sold all their holdings.

However, the markets soon bottomed out and eventually recovered to their old levels and well beyond.

Panic sellers may have missed the market rally, while long-term investors who stayed in the market eventually recovered and fared better over the years.

Suppose an investor bought shares of TCS in January 2006 and keeps them.

During this 16-year period, it would have experienced the global financial crisis of 2008, the sell-off of 2015, the pandemic of 2020 as well as the recent sell-off this month.

Yet today, his total investment would have increased by 1,534%.

Over a long enough period, even the biggest declines look like simple blips in the long-term uptrend of the market.

Unfortunately, in a falling market, investors tend to sell their winners too early because they fear those stocks will go down. It makes more sense to keep businesses strong during times when they tend to rebound.

Buy strength, not weakness

We’ve all heard of the stock market rule of thumb: buy low and sell high. When the market goes down, you can buy more shares at lower prices. But you can’t just blindly buy stocks just because they’re cheap.

It takes patience to do solid research on the company. In a falling market, the right strategy is quite simple. You must buy strength, not weakness.

Most of your new purchases should be in strong stocks and sectors. Allocate only a small portion to fundamentally sound stocks that have fallen significantly but represent good value.

When the markets rally, it’s really those strong stocks that would offer positive returns even in a bear market while the weaker stocks would stay in the red and probably even go lower. Investors could also follow the “cost averaging” strategy, whereby one can invest a designated amount every few days or weeks in such strong stocks. As the market continues to fall, you could buy more shares for the same amount of money. Over the long term, this strategy can lower the average price of the stocks you own and can generate higher gains when the market recovers.

Last words

Investment losses are painful, but if investors can stay focused on their goals, rather than obsessing over daily account statements, they would be better off in the long run.

Chaos and high volatility should not worry long-term investors. If you want to buy stocks, look for value stocks. They are less volatile and fairly insensitive to inflation in the current scenario.

In theory, selling your stocks just before an expected stock market crash is a smart strategy. You would sell when prices are still high and you can reinvest once prices are much lower.

But in reality, it’s next to impossible to do so because it means having to time it perfectly, not only for the sell part, but also to buy back at the right price before the markets turn around and go back up.

If you sell all your shares and hold on to cash, not only will you risk losing profits if you sell too soon, but if you wait too long to get back into the market, it may have already moved up significantly.

It makes sense to hold onto your investments for the long term if possible, because no matter how bad a crash is, you don’t lose money on your investments unless you sell.

The key is to invest in stocks with strong fundamentals. Not every business can get through tough times.

However, by investing in companies with strong underlying business fundamentals, your investments are more likely to recover.

It is prudent to know your risk tolerance in advance and choose stocks accordingly. This way you won’t panic during a stock market crash.

Good investment.

Disclaimer: This article is provided for informational purposes only. This is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com

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