Ininvestors are worried about a stock market crash and they are trying to figure out how to weather the storm. the S&P500 is down more than 10% so far this year, and more trouble to come looks likely. The obvious reaction is to sell stocks and avoid further losses, but that may not be the wisest move. Here’s why.
The market is risky right now
The Federal Reserve has taken an aggressive stance on its cutback schedule in recent months. Historically, stocks struggled when the central bank withdrew its monetary stimulus. Higher rates reduce investors’ risk appetite and economic activity tends to slow with a higher cost of capital. This does not guarantee that this correction will turn into a bear market, but a major catalyst has been removed.
Stock market valuations do not help the situation. Right now, stock prices are high relative to sales, earnings, cash flow, book value, and dividends. This is not the case for all stocks, but it is the case for the market in general.
This is especially true for index funds. Major indices are currently dominated by large-cap tech stocks, and they have higher valuation ratios than companies in other sectors. High valuations imply high growth and create more risk for investors. If growth is below expectations, a correction is almost certain.
There is evidence that the economic expansion could last a few years, but it is far from guaranteed. Unemployment remains high as workers navigate a new world after all the business closures and relocations that have occurred during the pandemic. Global supply chains have been permanently disrupted or altered. Inflation creates uncertainty at all levels. Hopes for an immediate recovery from the COVID-19 crisis have been dashed, making it harder to justify aggressive valuations in most equity markets.
All of this considered, the current market downturn is not shocking. These issues have still not been resolved, so there is likely more turbulence to come.
That’s still not a good reason to withdraw your money
Most investors shouldn’t sell their stocks right now, despite the risks. It might sound counter-intuitive, but there’s a ton of historical evidence that supports a tough approach in a market downturn.
Volatility and cycles are natural characteristics of the stock market. Investing in stocks is a great way to build long-term wealth as businesses grow. However, to realize these gains, you must deal with the short-term consequences of supply and demand. You can’t reasonably expect to enjoy all the good times without enduring some of the bad times along the way. History shows us that the good times outnumber the bad in the long run.
This is not much consolation for investors who see their net worth eroding every day in the market. It is tempting to panic and sell stocks to avoid losses. If you sold all of your stocks today, you would likely avoid further losses as interest rates rise and stock valuations normalize. However, you would open the door at the opportunity cost. Missing out on potential gains could be far worse than taking temporary losses this year.
When shares are sold to avoid losses, this capital must be redeployed elsewhere. Sellers attempt to wait out a stock market crash and then buy back shares before growth resumes. This plan makes sense on paper, but it’s nearly impossible to execute. Very few people can successfully identify market highs and lows. In the past, many of the best market days have come shortly after some of the worst days. That doesn’t leave much room for error.
If you bail out during corrections, you will likely miss out on growth. Investors could be beaten over the next few months, but that could be followed by strong returns later in the year. This is exactly what happened in 2009 and 2020. For most investors, the best strategy is to buy good stocks based on their company’s fundamentals and hold them for the long term.
Review your portfolio allocation
It’s a bad idea to panic and exit the stock market right now. However, it’s a good idea to make sure your portfolio allocation reflects your risk tolerance. The market will likely remain volatile this year. Short-term investors need to make sure they have the right balance between growth stocks, value stocks and bonds.
If your risk tolerance is low, it might be a good idea to reduce the amount of growth stocks – or stocks in general – in your investment portfolio. A risk tolerance questionnaire is a great starting point. The best investors develop a long-term strategy designed to work through entire market cycles with modest adjustments as conditions change. This is a much better plan than drastic course changes during predictable corrections.
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