5 Strategies for Handling a Stock Market Drop


by


25 January,2016

At the time of writing this, the stock market is losing ground. The Dow Jones Industrial Average is down more than 500 points, and the NASDAQ and S&P 500 are also struggling quite a bit. Global stocks are faring just as poorly, with indexes around the world dropping dramatically.

During times like these, it’s tempting to panic and sell. However, now is not the time to unload your stocks without careful thought. Here five strategies you can implement during a stock market drop:

1. Do Nothing

One of the best strategies to adopt during a stock market drop is to do nothing. Investors make terrible decisions when they are scared. Plus, selling during a drop violates the #1 rule of investing: “Buy low and sell high.”

While you don’t want to hold onto something just to hold onto something, the reality is that, for the most part, the stock market as a whole recovers from these down cycles. If you are invested mostly in index funds, selling now can mean locking in losses and missing out on future gains. Below is a table from Advisor Perspectives that shows the performance of the S&P 500 from the 1950s through most of 2014.

SPX-and-Recessions

As you can see, even though there are troughs in the performance, and times when there are losses, the reality of the situation is that, over time, the S&P 500 gains. While there is volatility now, over time the trend line tends to smooth out.

You can see that doing nothing during a stock market drop would result in gains over time if you are indexing. This holds true for a number of indexes, not just the S&P 500. Even if you are invested in individual stocks, you can see an advantage to doing nothing during a stock market drop. If you have chosen stocks that are fundamentally strong, riding out stock market volatility can be a smart move.

2. Sell the Losers (and Get a Tax Benefit)

You can sell during a down market and benefit, as long as you are careful about what you are selling. When you make the decision to sell, it should never be due to panic. Any decision to sell should be a measured decision.

As a result, a stock market drop might be the perfect time to unload some losers. Take a look at your investments. Have some of the fundamentals changed? Are you concerned about an asset’s ability to recover in the future? If this is the case, it can make sense to sell during a time of volatility.

However, you have to be ready to absorb the loss if you decide to sell a loser. The good news is that you can offset some of the loss and reduce the pain with the help of tax loss harvesting. Capital losses can be used to offset capital gains in other areas, and you can even deduct some of your losses from other income in certain situations.

This strategy worked well for me one year, after my basement flooded. I needed to liquidate a portion of my emergency fund (kept in a taxable investment account) to pay for some of the costs associated with the cleanup. I ended up selling during a stock market drop. I got rid of some losers — and took the loss. But it turned out ok. I got the capital I needed at the time, and I ended up with a tax deduction. So, I ended up effectively getting a tax deduction for what I paid for my basement cleanup. Not bad.

3. Rebalance Your Retirement Portfolio

You don’t want to chase the market, and attempt to time what’s going to happen. However, you can benefit from judicious rebalancing during a stock market drop. Check your asset allocation to see where you stand. If you find that you are getting a little off balance, now could be the time to sell. Figure out which assets are performing well. Chances are that something in portfolio is doing well as stocks drop. Sell a portion of what is doing well and buy a few more stock funds or stocks. Selling while one asset class is high and using the proceeds to go bargain hunting in another asset class can be one way to keep your retirement portfolio properly allocated.

Only make this move if you really do need to rebalance your portfolio, however. You don’t want to find yourself rebalancing to an asset allocation that doesn’t fit with your needs and your long-term goals.

4. Buy More

I like to keep a certain amount in cash reserves for just these occasions. When the stock market becomes dramatic, I am prone to buy more stocks because they are on sale. There are two main ways you can approach your effort to buy more stock during a drop:

  • Buy more index fund shares: You can buy more index mutual fund or ETF shares during a stock market drop. This is one way to take advantage of a drop in the market overall, or a drop in the index you invest in. To a certain degree, I automatically use this strategy since I have an automatic investment plan. If the market is down when my automatic purchase is made, I get more shares for my money. However, sometimes I make an extra order if the stock market drop is dramatic enough to provide me with a really good deal.
  • Purchase individual equities while they are on sale: If you are a value investor, this can be a great time to do a little bargain shopping. Look for stocks that are fundamentally strong, and likely only down because of market forces. Another good way to make the most of a stock market drop is to buy shares of dividend paying stocks. This can help you in the long run because you end up with more shares of a stock, which means a higher dividend payment next time, which in turn gives you more to reinvest, keeping the snowball rolling.

For many investors, a time of volatility in the market isn’t the time to get rid of their assets. Instead, it’s the time to look for good deals and buy more. If it works with your long-term goals, consider making some judicious purchases during a stock market drop.

5. Turn Off The TV and Stay Away from the Internet

If you are overly worried about the situation and tempted to make a move — even though you know that it’s not the right time — it could be a good idea to turn off the TV and stay away from the Internet.

Sexy headlines related to a stock market drop can whip you into a frenzy. Remember: many of these sites exist to try and get you to tune in or click. They do that by sensationalizing the news and convincing you that the world is about to end. No one likes a headline that tells you to remain calm and stay the course while you wait for gains over a 20-year period. That’s just not interesting or fun.

Don’t get overwhelmed by the herd mentality that threatens your portfolio and peace of mind. Instead, focus on the long-term. Tune out the noise, and do what helps you reach your goals.