As tends to happen, yesterday’s dramatic stock market decline has put some investors on edge. The other day, I talked with my friend who is a financial planner, and he told me that after the market dropped by 15% in early August, he couldn’t keep certain clients from selling. They were scared to be caught in a downturn like the one three years ago, and they just wanted out.
The problem, of course, is that selling in a panic is rarely a smart move. Remember the old adage: Buy low, sell high. When you sell your stocks or mutual funds after a market drop, you’re doing just the opposite.
(GALLERY: 12 Things You Should Stop Buying Now)
The best time to prepare for a market downturn is before it happens. I’m not suggesting that you should try to time the market upturns and downturns — nobody can do that reliably, not even the experts! — but that you invest in such a way that you don’t have to sell in a panic when the stock market decides to take a dive.
Easier said than done, right? How does one actually do this? Well, there are few ways to make your investing less emotional and more methodical.
- First, know your risk tolerance. Each person is different. For some, even the slightest possibility that they may lose money induces a stomach ache. Others are willing to risk potential losses of the potential gains are greater. I’m young, so can take on more risk; on the other hand, I don’t like risk. I’ve found that having 60% of my investment in equities is the perfect balance for my risk tolerance. You can learn more about your risk tolerance using the Rutgers investment risk tolerance quiz.
- Second, have a plan. Serious investors create an investment policy statement, a roadmap with guidelines that they and their investment advisors can follow. When the stock market goes crazy — soaring with irrational exuberance are crashing with irrational fear — the investment policy statement can help take the emotion out of investing. Morningstar has a crash-course in creating an investment policy statement.
- Third, be systematic. Once you know your risk tolerance and have an investment policy in place, you can invest systematically. You might use dollar-cost averaging, for instance, or dividend reinvestment plans. Or you might do what I do: Simply buy into the market once per year. If you have a system and stick to it, you don’t need to panic when prices fall.
Finally, remember that investing in general (and stock-market investing specifically) requires you to take the long view. You have to think in terms of decades, not years. (And certainly not months or weeks or days.) The younger you are, the truer this is.
(GALLERY: 15 Financial Moves to Make Right Now)
Over the long term, the stock market has historically returned an average of about 10% before taxes, which is more than any other assest class. (But also keep in mind that average is not normal.) Investing for the long term makes sense — and cents.
If I can’t convince you that a market downturn is no reason to panic, maybe the world’s greatest investor can. In his 1997 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
The next time the stock market takes a tumble, remember Buffett’s advice. And then go out and buy yourself some hamburgers!