The stock market can be a dangerous place. Fortunes are made and lost in the blink of an eye. While most investors are bullish overall, meaning they expect the markets to go up, even the most seasoned investors get skittish in certain economic and political environments. Here are four steps investors might take with an impending market downturn.
Liquidate Risky Positions
When some investors sense danger ahead, they follow along with the general sentiment and sell investments. Smart investors start by selling risky positions, like those with a high beta, or history of volatility, and those with new business models. Others sell their positions in even the most stable companies as protection against losses.
However, experienced investors do not follow the nervous investors who rush to sell everything and sit at the sideline. If you sell everything, you can miss out on big gains if the market bounces back from its lows.
Instead of selling everything, top investors just sell the risky investments in their portfolios while holding onto stable investments in firmly established companies, such as blue-chip companies.
Historically, large company stocks only lost money about one out of every three years, on average.
Some top investors don't sell when they feel a downturn coming, but they'll stop investing any extra cash they would normally invest. Investors holding large amounts of dividend stocks, for example, may turn off reinvestments and hold onto cash as a hedge against portfolio losses.
Hoarding cash allows you to weather the storm relatively unscathed if the markets turn sour. Even if your stocks lose a lot of value, investors with cash stashed away can wait for the perfect moment to begin investing again. The gains experienced when riding the market upward out of a recent crash can help offset losses in the stocks you held onto through the downturn.
Hoarding cash is not a long-term solution. Savings accounts earn low interest rates. Combined with inflation, your cash could effectively earn negative rates and ultimately lose value.
Shop Fixed-Income Investments
Investors may move their funds into fixed-income investments when the markets look unstable. Fixed-income investments come in many flavors, including bonds. Bond prices tend to move inversely to the stock market, so when stock prices fall, bond prices rise. In the event of a large market downturn, bond prices may fall along with stocks, although their yields should increase in turn.
The bond market is made up of different types of debt securities, including corporate bonds, government bonds, and municipal bonds. Corporate bonds are debt instruments issued by large corporations. Government bonds come in different varieties. Municipal bonds are issued by local governments, and they often come with a tax benefit.
Be aware that, if you bet big on fixed-income investments, they will lose value if interest rates rise. The individual bonds themselves will always pay out a predictable amount as long as the issuer doesn’t default, but prices rise and fall in the secondary market, where many consumers buy and sell bonds.
Buy, Buy, Buy!
Famed investor Warren Buffett once shared this gem of wisdom in his annual letter to shareholders: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
In other words, when the markets are flying high and people are bragging about profits, a fall in market prices is likely to happen soon. On the other hand, when investors are fearful and worried about poor conditions, a stark market upswing could be on the horizon.
One way to buy stocks during a down market is through a strategy known as dollar-cost averaging. This is when investors continuously contribute the same amount of money every month to their investments. When share prices are high, they may only be able to buy a few shares, but when prices are low, they'll be able to buy more. In the long run, this strategy lowers the average price per share that they own and can be a smart move if (and most likely when) the market rebounds.
These buying strategies are not without risk. While investing in a down market often pays off big, there's a chance that the market hasn't hit its bottom yet. But when the market finally does begin to rebound, you'll be enjoying larger gains than the people who didn't buy during the market slide.
The Bottom Line
Every investor has their own way of dealing with poor market conditions. Whether you choose to follow one of the strategies mentioned here, or you decide to form a unique playbook for down markets, the key is to avoid knee-jerk reactions. A slow and steady approach will produce the best results, regardless of what specific strategy you're trying to follow.