The stock market went into a correction this week, meaning that the market fell 10%. I really didn’t notice until I saw people over on the Choose FI Facebook page asking about what to do when the market goes down. That Facebook group is really diverse in terms of financial knowledge and attitude. Many don’t even listen to the Choose FI podcast, which is why there end up being a lot of questions about situations like this. I’ve seen way too many people panicking over a short term dip in the market and asking how quickly they should sell off all their stock positions and wait for the market to improve. Luckily others are quick to jump in and give sound advice to hold on, but if the response to the crash is any indication, too many won’t listen and sell anyway. Market corrections like this is when we learn our true risk tolerance. Every investor needs to consider risk management. Too much risk can feel like gambling, but not enough risk means missing out on more compound interest. Let’s think about risk management in terms of Kenny Roger’s famous ballad The Gambler.
You Gotta Know When to Hold Em....
From my perspective, dancing in and out the market whenever it looks like the market might drop is a great way to lose money. Besides locking in your losses when the market does go down, constantly trying the market is a losing game. This article from the Motley Fool illustrates this best. Between 1999 and 2018 (including one of the best bull markets in history), you would have managed to lose money if you weren’t in the S&P 500 index on the 20 best days that the market had. Many of those days were immediately preceded by market drops! So if you always sell when the market goes down and buy back in after it starts to go up, chances are you’re losing in the long term. A buy and hold investor should do just that, no matter what the market does on a daily basis.
Know When to Fold Em...
Objectively, investing in 100% stocks is a risky strategy. The stock market goes down and goes up. Statistics show that being 100% in stocks yields the best results long term, but it’s okay if you can’t stomach short term losses! It’s stressful to see the line go down and to the right. The answer is not to sell and lock in losses, especially in an index fund. Diversification is the right way to go. Having a portion of your portfolio in a bond index will help to offset losses in a down market. Typically when the market goes down, the value of bonds go up. At this point, you can sell off some of the bonds to buy the stocks that are “on sale” and rebalance your portfolio. Having money in bonds reduces the overall returns over the long term, but it’s just as important to know your personal risk tolerance. If having 20% of your portfolio safely in bonds helps you sleep at night, go for it. Personally, I only have a small portion of my portfolio in bonds. I’m far from retirement, so I’m not stressed about short term tips in the market.
"Buy the Dip"
I’ve seen this phrase being tossed around a lot lately. In certain situations, it is sound advice. It isn’t always good advice when referring to individual stocks. Sure, many stocks will rebound but I wouldn’t count on GameStop ever returning to the brief heights that it reached. In terms of index fund investing, I believe that buying in when the market is “on sale” is huge. When the market crashed back in March, I bought in on the way down and back up. I took advantage of the fire sale and got great short term returns. These gains will only compound more over time. I’m not advocating for timing the market. I didn’t sit on the sidelines and wait for a crash. But when the crash did come, I was more aggressive with putting money into my low cost index funds.
Making a Plan is the Key to Risk Management
The Choose FI podcast is a treasure trove of good finance advice, especially for those pursuing financial independence. One of my favorites is the recommendation to make an investment plan at a time when you can be as objective as possible. This should include coming up with a portfolio allocation (even if it’s primarily put into a total stock market index fund). It should also include what you’ll do when the market goes down. And then stick to your plan! If you decided to invest more when the market goes down, then do so. If you decided to just rebalance when the market changes, then do that too. The important part is to gauge your risk and act according to a predetermined plan instead of your emotions. With a detailed plan of what your goals and methods of investing, you can see a crash or correction as an opportunity instead of a catastrophe.
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Disclaimer: I am not a professional investor nor am I a professional financial advisor. I write article based on what I personally do. I cannot guarantee any results in the stock market.