The Dow Jones stock index dropped nearly 400 points last Friday, unsettling investors who have much of their wealth tied up in equities. Some investors are tempted to pull their money out of the market amid such volatility, fearing a coming downturn and wanting to protect their stakes.
While that impulse is natural, most financial advisors counsel against rash moves, pointing out that equities historically are an excellent long-term investment and that selling during a down period locks in losses. Indeed, the market recovered this week after Friday’s sell-off.
We talked with Brad Sherman, a financial advisor in Gaithersburg, Maryland, and a member of NerdWallet’s Ask an Advisor network, about the psychology of investing and what investors should consider to navigate the ups and downs in the market.
When the stock market hits a bad stretch, how do investors react?
Many investors tend to panic when markets have a significant, sudden downturn, which is unfortunately one of the worst things you can do. We see too many individuals who listen to the news and get scared about the markets without fully understanding what’s going on and whether it is even news that will affect them.
Our clients generally don’t have the typical reaction to big market drops, because we’re constantly talking to them about risk. We’re proactive about reaching out to them and explaining what’s going on and how they may or may not be affected.
What do you tell clients?
We preach the importance of risk management, understanding your full financial picture and understanding how your financial plan fits your needs and situation. Market volatility is normal, and markets historically have rebounded extremely well after corrections, which are defined as drops of at least 10%.
Where investors get in trouble is when they don’t plan properly for volatility and their investment portfolio doesn’t align properly with their goals and risk tolerance. This can cause an investor to make the biggest mistake, which is panicking. On the flip side, when you have a good understanding of how much risk you can tolerate, you’ll feel much more confident about your investment strategy.
What specific things should investors do?
Take a step back to avoid making an emotional decision. While the S&P has returned an average of almost 10% annually the 1960s, those returns are not consistent. One year the market could be up 20%, and the next it could decline 12%. To make the ride even bumpier, the market also has streaks during which returns decline for several consecutive years. That’s when investors often begin to panic and pull their money out.
Unfortunately, that’s usually the worst time to do so, and it’s when investors often should be increasing their investments instead. To help with this, we recommend that our clients break out short-, medium- and long-term goals. If their investment portfolio is there to help them solve for long-term goals, then in almost any situation, a market correction — even a big one — shouldn’t have any impact on them.
Anything else investors should keep in mind?
Volatility can actually be a great opportunity for investors. For example, it can work in your favor if you’re implementing some type of regular contribution strategy, such as dollar cost averaging, where you’re investing a fixed amount of money on a set schedule no matter where the market is. As a result, that fixed dollar amount buys more shares when the market has dropped and prices are low, and it limits the amount of shares when the market has risen and prices are high. Over time you’ll come out ahead, compared with trying to time the market.