Avoid Self-Inflicted Losses In A Down Market

Downturns in the financial markets are an uncomfortable part of investing. Taking steps to plan ahead in a down market is best, no matter what you do during the a sale is also important. Especially for equity investors, avoiding loss completely is unrealistic. But individuals sometimes make decisions that cause preventable financial loss. Here are three ways to reduce the risk of incurring unnecessary, self-inflicted losses in a down market.

A stock ≠ the stock market

You’ve heard it before: past performance is not indicative of future results. It’s not just legalese – it’s real – and the chart below shows why. at this point. After years of strong performance…

…newly public companies and seasoned stocks alike have experienced dramatic drawdowns. Compare these drawdowns to the Russell 3000 and the stock’s upside market not look that bad.¹

For a stock, drawdowns like this are not uncommon. According to JP Morgan, between 1980 – 2020, roughly 45% of the stocks in the Russell 3000 fell 70% or more from their previous peak and never recovered. Almost a coin toss.

Make no mistake, investing in a single company (perhaps from the employer’s stock options) can yield huge returns, far more than a diversified index. The issue is when investors don’t properly size their risk, understand their exposure, or know when to take profits.

Checking your accounts will do more harm than good

One way investors can incur unnecessary losses is to check their portfolio during market downturns. To illustrate, the chart below plots the one-year total return for the S&P 500. The purple line shows day wins and losses as the orange line reports MONTHLY.

Both have the same net result.

But if you check your account every day you have more more ups and downs to deal with. Wild swings in the market can stress you out at best, and at worst, prompt you to make rash investment choices that can create self-inflicted losses.

So if you’re not planning to change, what’s the point of looking? If there is a reason to trade, make sure that change bias does not influence the decision.

Pursuing the market

It can be tempting to make changes to your portfolio after recent events. When looking at various equity indices for company size and factors, there is little correlation between the best or worst performers over the past month or year compared to longer periods of time. In fact, recently, the result was reversed.

One-month returns in the small-cap, high-dividend, and defensive sectors, and the value is quite impressive. Despite going out for seven years, these indices are the worst performers. Does that mean you shouldn’t have investments with these characteristics in your portfolio? No! This only shows the importance of diversification. Markets are cyclical.

When you’re looking at your account every day, it’s tempting to sell the losers and chase the winners. This can have lasting implications. These charts also highlight the difficulty of tax loss harvesting. Harvest losses for tax purposes only can have wider implications due to wash sale rules.

If you sell an investment for a loss, you cannot buy the position (or an equivalent one) back for 30 days. So you buy something you don’t want or keep money. The market can move significantly during this period – four indices above have gains of more than 10% in a month.

This is not an anomaly either. According to Bespoke Investment Group, since 1928, the S&P 500 has averaged a 15.2% return in the first month of a bull market. During the first 3 months, the average profit increased to 31.6%. What the market will do coming out of the 2022 bear market is anyone’s guess, but historically, markets move quickly, and the best market days often fall within one or two weeks at worst.

Silver lining! Market shifts present opportunities

Changing market conditions may not all bad news. Rising interest rates are bad news for stocks, bonds, and home buyers. But, for individuals with money, this is a big win. One year Treasuries are currently yielding 4.75%…versus .17% a year ago (November 2021). That’s a 2,700% increase! Investors can build a Treasury ladder or simply buy longer maturities to lock in returns.

Even high-yield savings accounts provide a decent cash return. There’s no reason to park a lot of money in a 0% interest-free checking account when you can enjoy a safe 3% APY in the right savings account.

However, individuals are not advised to dump their portfolio and buy Treasuries! But for some investors, the yields are attractive enough that Treasuries should be part of the conversation when considering the allocation for a new cash investment.

It also highlights the nuances of investing and why some things are black and white. Not checking your account every day doesn’t mean never checking. And the passive buy and hold strategy should not ignore the balancing of needs, the right opportunity to harvest tax losses, or periodic evaluation of the fund.

In down markets, there is a tendency for people to want to move. To do one thing to stop losses. Acting on this urge often (though not always!) turns out to be an unwise decision. It is also probably the most common way investors manage their own portfolio to avoid avoidable financial losses.

¹ Total percentage return from high, Russell 3000 drawdown roughly -22% to 11/3/2022. The Russell 3000 represents nearly 97% of the US equity market.

Source

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