3 Biggest Mistakes Investors Make In Volatile Markets
Investing through market volatility can be challenging. Should you go to cash? What investments perform the best during a market selloff? Is it a good time to consider tax-loss harvesting or buying the dip? Often, the best time to evaluate or make changes to your portfolio is before volatility arrives, not after. If you're unsure whether you should take any action, then you probably shouldn't. Staying the course through market volatility usually rewards the patient investor. Here are the three biggest mistakes investors make during a market 'crash'.
Selling to cash
The biggest mistake investors make when stocks fall is to cease being an investor and sell to cash. Why? Because it's practically impossible to perfectly (or even adequately) time your exit from the market and your reentry. Investors often focus on selling and give little thought to when they put cash back in the market again. This is a big mistake.
Importance of staying invested
Further, adding to the difficulty of trying to time the markets, most of the best days happen around the worst days. Over the last 20 years, 70% of the best 10 days happened within two weeks of the worst 10 days. Incessantly going in and out of the market erodes returns and can have tax implications, transaction costs, etc.
Not putting extra cash to work
Everyone loves a sale, except when it happens in the financial markets. Fear over short-term volatility can lead investors to hold off on investing money they otherwise would have put to work. For long-term investors, the question of whether it's a good time to invest shouldn't have much to do with current market conditions at all.
If you have extra cash, a multi-year horizon, and you've considered what else you could do with the money (such as pay off high cost debt), then it likely makes sense to invest the money in a diversified portfolio. Being able to buy assets cheaper because of market volatility is an added bonus. If you're worried about volatile markets, consider dollar-cost averaging vs investing a lump sum.
Searching for the bottom isn't an investment strategy. There are no smoke signals. No all clear sign. Investing is about time in the market, not timing the market. Buying low and selling high sounds great, but over time, markets go up a lot more than down. So this approach can actually leave you worse off.
According to data from Dimensional Fund Advisors based on the Fama/French Total US Market Research Index, between 1926 - 2020, the average annualized returns for the five-year period after a correction (10% decline) was 9.5%; after a bear market (20% decline) was 9.7%; and after a 30% decline, 7.2%.
Compare this to investing in the S&P 500 between 1926 - 2021 after the index closed a month at a new high. Dimensional Fund Advisors reports the average annual returns over a 5-year period after reaching a record was just over 10%.
Most investors would (and should) be pretty happy with any of these figures.
Forgetting to diversify
Diversification isn't a magic bullet, but it is perhaps the best tool investors have to protect their portfolio from volatile markets. At the most basic level, adding bonds to a portfolio can provide stability and income. But this is just the tip of the iceberg. Asset classes respond to market conditions differently. Further, the correlation and diversification properties within an asset class are also critical to managing market volatility.
The goal of diversification is to smooth investment returns over time and potentially even outperform a concentrated portfolio as a result. As investors move through life, limiting downside risk can become more critical than further upside. This is particularly true when beginning to draw from your portfolio in retirement. By taking steps to limit wild swings in your portfolio, it increases the odds you'll have the fortitude to stay the course.
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Article initially appeared on forbes.com
Credit: forbes.com, NYSE, JP Morgan
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