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The "Financial Planning Blueprint" Blog

  • Writer's pictureJason Flurry, CFP

What to do when the stock market drops

5 proven tips to help you survive and keep your peace

Legend has it the J.P. Morgan in John D Rockefeller both offered the same financial advice to young financier who asked them what the market was going to do. Their answer was, “Son, it is going to fluctuate.”

Of course, nobody really knows for sure what markets will do in the short run, but over the long run history has shown that markets rise over time. That’s good, but it doesn’t mean that the ride upwards is always a smooth one. In fact, it’s often just the opposite with the market taking two steps forward and one step backwards. Sometimes that backward steps can make you feel like you fallen down the stairs, so today I’m going to talk about what to do when the market drops. I’m even going to give you five tips and strategies you can use to survive a market downturn and keep your piece. Market declines are not surprising events – they’re reoccurring events. If you prepare yourself for them, like you prepare for winter in the fall each year, you can get through them much easier.

1 - Review your portfolio in advance expecting the markets to go down. Most people take on way more risk than they think they have and they don’t realize it until the market drops and takes a lot of their savings with it. It’s easy to overlook your risk levels or get lazy when it comes to rebalancing your holdings when markets are rising, especially if they continue rising for as long as this current market has. Sure, there have been some quick corrections where the market has dropped 10% or 15% in a few weeks in recent years, but for the most part, letting everything just ride has proven to be a pretty good strategy for the last 8 to 10 years.

Over the past 100 years, we’ve typically had market drops of 20% or more happen every 3 to 5 years. If you been riding this wave higher for longer than that, consider yourself lucky and use this message as a wake-up call to take an inventory of what you have in place in your accounts.

Now, I’m not saying that the markets are about to head down immediately, but it wouldn’t surprise me if they did. Protecting what you have and avoiding losses will help your accounts grow much faster and more consistently over time. And, just like taking care of yourself by eating healthy and exercising can help prevent catastrophic diseases from ruining your life, taking some preventative measures to review your accounts while times are still good can make a huge difference in your financial well-being too.

2 – Protect yourself. Timing the market has proven to be a fool’s game. And, since I think we can all agree that markets do fluctuate, one way to protect yourself is to use something called a stop order. Stop orders are not available for mutual funds, which is where a lot of people’s money is held, especially in retirement accounts like 401(k)s. In those situations, you really have to monitor things more closely and make sure you keep things balanced so you don’t get caught by surprise.

Stop orders are really designed for stocks and exchange traded funds only. They can serve as a safety net underneath the current price of an investment and either help you lock in gains should prices begin to fall or cut your losses if something drops below the price you paid for it. The way a stop works is you set a price below whatever the current price is and if the current price reaches your stop price, your stop order becomes a market order. That means that your trade is activated at whatever the next available price is for that investment on the open market. When you place a stop order, sometimes the actual sale price is slightly different than what your stop price was, but if you’re using it to protect profits or cut losses, getting close to the price you selected is usually good enough.

Depending on where your investments are managed, you may be able to use something called a trailing stop. In that situation, you set your stop price below the current market price and if the investment you own goes up, your stop price will follow it by whatever percentage or dollar amount you indicate. For example, if you had a position in an individual stock and let’s say that stock is currently trading at $100 a share, you may want to put a 10% trailing stop order in place to protect. If the stock drops from $100 a share to $90 a share, your order to sell activates and you would likely get something around $90 a share automatically when those shares are sold. That’s how normal stop works.

The trailing feature here though keeps that 10% spread in place if the stock moves higher. So, instead of your stock dropping, let’s pretend it actually goes up $20 a share instead. If you had a regular stop in place, you would still be protecting those shares at $90 a share. However, with a 10% trailing stop, your stop order would follow the price of the stock higher and adjust automatically. So, if your shares grew to $120 a share, your 10% trailing stop would move up to $108 per share, or 10% below the current market price of $120.

Trailing stops can be very helpful, especially if you have positions that are prone to volatility. If a particular investment is more volatile, usually you would give it more room to wiggle as you set your percentages in a trailing stop. You don’t want to be stopped out to soon due to normal behavior and the regular price fluctuations that investment has.

Finally, trailing stops are useful when you need money or you’re trying to get as much as possible for position you intend to sell. In these situations, you would probably place a very tight trailing stop on that investment so that if it backs up at all, you lock in your sales price. If it keeps moving higher, you follow right along with it and you don’t have to try to guess the top of the market as you go.

Stop orders and trailing stop orders can provide a nice hedge to the growth portion of your investment portfolio. The pros definitely know how to use them and if you have individual stocks or exchange traded funds as a part of your portfolio, it’s in your best interest to learn how to use them too.

3 – Hang on. If your portfolio is well-balanced and you own a diverse mix high-quality investments, one of the best thing to do when the market is dropping can be to simply not look at your statements for a while. Seeing your balances go down will only upset you and cause you to make emotional mistakes.

You can think of market declines a little bit like power outages during a storm. I don’t know about you, but whenever the lights go out, the first thing I do is look out the window to see if my neighbor’s lights are out too. When I see that they are, I understand that it’s something on a bigger scale that’s causing it and I can relax a little knowing that in time everything will work itself out.

On the other hand, if my lights go out and I look out the window and see everybody else’s lights are still on, now I know we have an entirely different problem. That kind of situation is going to need a different approach. And, while things do break and stuff happens from time to time, is highly unusual for most people to suffer isolated situations like this with their electricity and with their investment portfolios. Usually everybody benefits or suffers from the markets movements at the same time. There’s no reason to get worked up about it. It’s just a part of the process and you can relax knowing that the markets have seen some pretty rough things over the years and still survived.

Unfortunately, many studies have shown that investors who don’t take this type of approach have not done as well as the markets over time. There’s a distinct difference between investment performance and investor performance and a lot of it has to do with people making irrational decisions based on emotion. If you’re prone to reacting to bad news rather than viewing it in the context of the bigger picture, especially when your financial goals are concerned, respect the fact that prices are dropping in the markets, but don’t defer to them and make a foolish decision you may regret later. Whatever is causing the problem likely has nothing to do with you individually, so go on about your business and spend your time and energy on something where you can have more impact.

4 – Be patient. Much of what moves the markets over time can be traced back to two things: fear and greed. Money does crazy things to our minds and our emotions and you’ve probably seen examples of where people have been greedy and ruined their lives and their families as a result. Bernie Madoff is a good example of this. Naturally, we all want to do the best we can, but we can’t let greed pushes too far on the risk spectrum so that were exposed to losing what we’ve worked so hard to build.

In my experience, I’ve found that fear is a much more powerful emotion and greed, especially when it comes to your savings and investments. It can be very difficult to hang on when things are dropping fast, even when you know that you’re prepared for it and that it’s a system-wide event versus something specific to you. But, if you can weather the storm, there’s usually a remarkable benefit waiting for you on the other side. The problem is though you don’t really know when the storm is over without the benefit of hindsight.

The temptation can be to get back involved too soon and try to take advantage of a market that appears deeply discounted. Rarely will you or anybody be able to consistently sell at the top or buy at the bottom, so don’t feel pressured to make a move in either situation. Once you’ve mastered your fear, it can be very difficult to then also keep your greed in check. But, I can tell you from personal experience managing client’s portfolios through several severe market downturns, that trying to catch a falling knife in the market can be dangerous. If you’re off just a little bit in your timing, the pain can last for a good long while.

See, I believe it’s much better to be patient, let the market establish its bottom and begin to turn, and then wade back in to take advantage of the treasures that can be found after a bear market passes. If you’ve properly balanced everything with your investments in the beginning and if your rebalancing along the way based on percentages, you will naturally buy low and sell high as a discipline. That takes the pressure off of having to be right each time you make an investment decision and it helps remove risk and speculation in your investment approach. Following the steps I’m giving you here and exercising a healthy dose of patience will help see you through just about anything you face.

5 – Stay focused. When the markets are dropping, it seems like everybody is interested in talking about it. The financial media and mainstream medium really hype up market declines because they know that bad news always sells more than good news. If they can touch your fear and make you feel like you have to stay tuned in, that improves their ratings. As ratings go up, so do their ad revenues. And all of this is in their best interest, but not in yours.

One of the best things to do during market declines is ignore most of what you hear in the news. I’ve found that most of it is not actually news, but rather just noise that’s designed to keep you stirred up and worried about everything. Instead of letting all of the get to you, stay focused on your goals. If you followed my advice from earlier, you’ve built your financial strategy in advance expecting downturns and market corrections to come along periodically. It’s normal behavior, right? So you should build in a risk level that accounts for it in advance. Knowing that you have that in place can keep you focused, help you hang on, and give you the patience to make your next moves when the market environments are more favorable.

Earlier I used the analogy of preparing for market declines like you would prepare for winter, and market declines are a lot like winters in the sense that some are easy and some are difficult. You never know in advance which one you’re going to get, but you do know that it will come. And, just as spring always follows winter. The tough times will eventually pass and easier seasons will follow. That’s the way it’s been for as long as we’ve had financial markets and you can expect more of the same on the road ahead.

Take to heart what I shared with you today. Review your savings and investments to make sure you’re not taking too much risk and that you have a true allocation that protects you from market declines. It can be challenging to see the picture when you’re in the frame, so if you need some outside help determining how well your portfolio would survive the market downturn, let us know. It won’t cost you a thing to get a second opinion from a CERTIFIED FINANCIAL PLANNER™ Professional and knowing that you have all of your bases covered can help give you a lot of peace of mind.


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