How Should You React to Falling Stock Prices?
While alarming, plunging share prices may be an opportunity for profit
Watching the stock market fall in real time can induce fear and panic, and that’s exactly what happened in late February and March of 2020.
The S&P 500, an index that serves as a bellwether for the U.S. stock market, fell almost 34% between Feb. 19 and March 23, 2020.
Losing roughly a third of your investment portfolio’s value in just a month may cause you to want to sell to prevent future losses. But if you don’t need your investment funds anytime soon and have some extra cash flow, buying more stocks at a reduced price may be a better choice.
If you’re looking to take advantage of falling stock prices, here’s what you can do to potentially earn a profit.
Why Falling Stock Prices Can Scare Investors
When you’re shopping for groceries and other goods, lower prices are generally viewed as a good thing. But with stocks, a plunge in prices sparks the desire to sell instead of buy.
Why is that? Because when you’re buying milk or bread from the grocery store, choosing a lower-cost item saves you money. In contrast, a falling stock market essentially costs you money in the form of an investment loss, and that’s scary, especially when retirement or other important investment goals are at stake.
Until you sell, however, those losses are what are called “paper losses,” which means they’re unrealized and impermanent—a stock market recovery can cancel losses and return your portfolio to its original position, or even to a better one. If you decide to sell your stocks while the stock market is falling, though, the losses aren’t just on paper—they’re now a reality.
If you stop investing during a market plunge, you could end up missing out on a rebound in prices, which would help you turn a profit.
Investing Tips When Stocks Are Falling
If your financial situation gives you some room to take advantage of falling stock prices, here are some ways you can potentially turn that drop into a long-term profit.
1. Focus on Diversification
One of the best ways to reduce your exposure to risk when the stock market is falling is to diversify your portfolio—this means investing in different types of stocks and other assets, such as bonds, mutual funds, real estate investment trusts (REITs), and more.
Each of these asset classes provides different levels of risk and potential returns, so including assets across the risk/reward ratio spectrum in your portfolio can help mitigate some of the heavier losses you may experience with some holdings.
2. Think About Your Time Horizon
Time horizon in investing refers to how long you expect to hold onto your investment. If it’s a retirement account, for instance, your time horizon is the year you plan to leave the workforce—which could be in 20 years for some people. If you’re investing money for other purposes, your time horizon is the date you expect to sell your investments to realize your goal.
The longer your time horizon, the more short-term risk you can take on. If you need the money in the next couple of years, though, you may not want to take on too much risk.
3. Avoid Trying to Time the Market
Guessing what’s going to happen with a particular stock or the stock market as a whole isn’t a good investment strategy. While there are certain fundamentals that can tell you whether a stock is a good investment, the stock market can still be incredibly volatile and unpredictable.
Instead of trying to time your investment to maximize your profit, consider using an investment strategy called dollar-cost averaging. With this approach, you invest the same amount of money every month into the same investments.
Dollar-cost averaging helps you remove the emotional component of investing from the equation. It also gives you the chance to “buy the dips” without trying to time the market and can reduce some of the uncertainty of whether you’re getting a good price.
4. Look at the Fundamentals
It’s important to understand both the strengths and weaknesses of each stock you own. With some research, you can find out how a certain stock performed in past market downturns and what its chances are of recovering from the current one.
Take some time to research your investments to understand the fundamentals of their underlying businesses and how an economic crisis will affect them.
In other words, understanding the fundamentals of the companies you’re investing in can help you determine whether a price plunge is a sign of long-term struggles or just a short-term blip.
5. Consider Working With a Professional
If you’re a novice investor, a financial advisor can help you learn more about the process and give you some personalized advice on how to approach your portfolio. They may be able to help you diversify your portfolio, switch your investing strategy from aggressive to conservative, and more.
Even if you’ve been investing for a while, an advisor can provide an objective view of your investment strategy, and help you ensure that emotions don’t control your investment decisions.
The Bottom Line
Whether the stock market is falling due to a larger economic crisis or simple everyday volatility, take a step back to think about how you can take advantage of the situation. Create a strategy to diversify your portfolio, research your investments, and avoid trying to time the market.
Also, understand how much risk you can take on based on when you’ll need the money you’re investing, and consider working with a professional to help you ensure your approach is effective and, hopefully, profitable.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.