Sometimes it’s easier to focus on what not to do.
On Wall Street, the bears are starting to roar.
During three trading sessions from August 1 to 5, stock prices plunged due to a combination of weak economic data, recession fears and a surprise interest rate hike by the Bank of Japan that triggered the unwinding of a global carry trade. In just three sessions S&P500 (^GSPC 2.30%) lost 6%, and the Nasdaq-Composite (^IXIC 2.87%) was down 8%.
For investors rattled by this volatility, it’s important to remember that what they don’t do during market declines can be just as important as what they do. With that in mind, here are three common mistakes to avoid when stocks are falling.
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1. Buying shares on margin
Trading on margin is dangerous in any market environment, but borrowing money from a broker is especially risky when stock prices suddenly fall.
As tempting as it may be to invest on margin, increased volatility increases the likelihood that you will face a dreaded margin call when the brokerage forces you to liquidate your holdings, or at least part of them.
A margin call during a sell-off can be devastating because you’ll be forced to sell your shares when prices fall, owing money to your broker and potentially missing out on the chance to capitalize on the sell-off.
You don’t have to just take my word for it. Here is Warren Buffett’s advice on trading on margin from his 2017 Berkshire-Hathaway Letter to shareholders:
There’s simply no way to predict how far stocks can fall in a short period of time. Even if your credit is small and your positions aren’t immediately threatened by the falling market, you can be unsettled by scary headlines and breathless commentary. And a restless mind won’t make good decisions.
Even in good times, trading on margin is too risky for investors like Buffett.
2. Panic selling
If borrowing money to invest during a correction is a mortal sin, then panic selling is arguably the second most common sin. The timing of a market recovery is difficult to predict, and you don’t want to be holding cash when it happens.
If you ignore the tax implications of selling your stocks during a decline, selling is the easy decision. Deciding when to re-enter the market is the hard part, and there is a psychological barrier that makes it difficult to get back in. After all, the bottom of the market is only clear when you look at it in hindsight.
Although it may have been tempting to sell on Monday morning when the Nasdaq opened down 6%, but the free fall won’t last forever. The U.S. stock market has recovered from every sell-off to reach new all-time highs, and this time will be no different.
There is no need to panic. You don’t even need to check your brokerage account or read the financial news. The stock market will eventually stabilize and so will your portfolio if you stay in the market.
It’s also reassuring to remember that market corrections are normal. In fact, they happen about every two years, and bear markets (declines of 20% or more) occur on average every four to five years.
3. Find the right market time
Even if you haven’t sold stocks before, it may be tempting to time the market just right. But that’s a lot harder than it seems.
Short-term movements in the stock markets are difficult to predict and are often triggered by unexpected events. The recent interest rate hike by the Japanese central bank surprised investors and triggered a wave of selling around the world. Last week’s economic data, including the unemployment report, were also weaker than expected, which further fuelled the sell-off.
It is unclear what catalysts could trigger a market recovery. Investors are eagerly awaiting the Fed’s next decision in September, now expected to be a 50-point cut, and are hoping for further insight from Fed Chair Jerome Powell at the Jackson Hole conference later this month.
But sentiment changes quickly and any number of events can push the market up or down. Rather than trying to find the right time to enter the market, consider a methodical approach such as dollar-cost averaging. You could also deploy a portion of your cash depending on the depth of the sell-off; for example, 20% for a 10% drop, 30% for a 20% drop, and 40% for a 30% drop.
You can follow Warren Buffett’s advice again here. On the topic of market timing, Buffett said, “I think it’s probably impossible to predict bottoms. When you start getting a lot for your money, buy it.”
Buffett’s emphasis on seizing value when it arises rather than hoping to find the absolute lowest price is key here. This approach has a much higher chance of lasting success than repeatedly correctly identifying the market bottom.
