This topic is relevant now more than ever. Over the past year, we've been on the cusp of bear market territory a few times, and that has a lot of investors scared. The consistent slide in stock prices that we've seen time and time again has partially been caused by investors' fear of losing everything. This is a common occurrence during a correction. Investors read articles about falling prices of equity and commodities and they feel the need to pull their money out. In this article I'm going to discuss the negative side-effects long-term investors experience when they pull their money during corrections.
“I'll just reinvest it when the market goes back up.”
There are 2 things wrong this kind of thinking:
#1 – No one has any idea when the market is going to recover. Even the best analysts can't determine when the market will give up this relentless downward trend. There are good simulations and indicators that help determine when the market is ready to grow again. However there isn't a magic recipe that will tell you when to reinvest again.
Long-term investors risk losing out on potential gains because they pull their money during bad times and wait for an upward trend. We've seen it before. In 2008 investors pulled their money when the markets were way down, and reinvested their money at basically the same place they took their money out. Essentially they incurred trading fees and hassle in order to get nowhere. Don't get me wrong, some people did take their money out at opportune times, and were able to buy good value equity, but it's rare to find and predict.
#2 – What happens if it's just a fluke? Corrections come in all shapes and sizes. This one happens to be a good sized one, but if you get into a habit of pulling your money out when you smell other investors' fear, you run the risk of getting out before the market is about to rise dramatically. The market works in strange and mysterious ways, and a single article from a reliable source stating that equity has reached a good value could spur a rally. Don't be fooled by pessimists!
If you are properly diversified, your investments will be hedged against massive losses. If you have any questions about diversification, read our entire article outlining the basics here!
Investor Fear Compounding
Investors talk to each other. Even if you don't write articles or blog about what's going on with the market, you may talk with your friends about how well the economy is doing. “Have you checked the Dow recently? It's really taking a dive.” Conversations like this spread fear between fellow investors and this compounds losses.
As more and more investors become fearful of “the end of the stock market as we know it,” the panic spreads faster and faster. Once again: don't be fooled by pessimists! People get scared when they see their money float away, but like we talked about in Don't Try to Beat the Market, our economy will recover stronger than ever!
I read 3-4 articles a day explaining how and why we're going to lose 80% of the value in equity, and it just makes me chuckle. All investors, new or old, have to understand that the market is a product of the people. We vote with our dollars. Curbing investor fear, finding attractive value stocks, and being consistent* in your investing approach will help you through these times.
“Should I do anything differently?”
*– In the last paragraph I said to be consistent in your investing approach, and I stand by it. That being said, I would like to add that during corrections many investors take a slightly different approach. If you are really worried about the market going down and you don't enjoy your money disappearing, try this:
Instead of putting parts of your paycheck in your index/mutual fund, keep it as cash or invest in bonds. Don't pull the money you have already invested in the market, but save up capital for the inevitable upswing. When you see things improving, immediately put your little pile of cash into whatever you choose and watch it grow.
This way you're not incurring trading fees to pull your money out, you won't lose large potential gains on the money you already have invested, and you can get some benefit from improved value in equity. I personally do this and it lets me sleep easier at night.
My site CollegeInvestr.com covers topics ranging from basic budgeting to market research and commentary. My main focus is to provide information for young investors trying to build wealth and reduce student loans. If you’ve liked this article, come check out more of my material!
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David's main goal is to provide finance and investing education to young college students looking to pay off student loan debt and increase wealth.
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