10 Tips for Investing in a Down Market - dummies

10 Tips for Investing in a Down Market

By Eric Tyson

Here are some tips on how you can maximize your chances for investing success when stocks take an extended turn for the worse in a down market.

Don’t panic

No one enjoys turning on his car radio, clicking on his television set, or logging on to the Internet and getting this news: “Stocks plunge. The Dow Jones Industrial plummeted 400 points today.” When you hear this news, don’t panic — it’s just one day’s events.

Don’t shun stocks, which produce terrific long-term returns, just because of the down periods. Risk and return go hand in hand. If you want wealth-building investments that provide superior long-term returns, you must be willing to accept risk (that is, volatility and down periods). You should take sensible precautions — with diversification being the star of the show — to reduce your risk.

Keep your portfolio’s perspective in mind

Having a diversified portfolio can help in a down market because some investments will increase as others decrease, thus balancing the losses. Even if the market is down 20 percent, your portfolio might be down a much smaller percentage, if you’re diversified.

View major declines as sales

Unlike retail stores, which experience larger crowds when prices are cut, fewer investors, especially individual investors, want to buy stocks after they’ve suffered a sharp decline. However, when stock prices decline, don’t get swept up in the pessimism. View declines as the financial markets having a sale on stocks. Stocks usually bottom when pessimism reaches a peak. Why? Those who were motivated to sell have done so, and the major selling has exhausted itself.

You shouldn’t randomly buy just any stock after a significant decline. When technology stocks started declining in 2000, some investors made the mistake of buying more of them after prices dropped 10 or 20 percent. What such “buy on the dip” investors didn’t realize was that the technology stocks they were buying were still grossly overpriced when measured by price-earnings ratios and other valuation measures.

You’re best off buying stocks gradually over time through well-managed, diversified mutual funds and exchange-traded funds. When the broad stock market suffers a substantial decline and stocks are at reduced prices — on sale — you can step up your buying.

Identify your portfolio’s problems

Stock market declines can be effective at quickly exposing problems with your portfolio, such as having too many investments from the same industry.

In addition to revealing poorly diversified portfolios, a declining stock market can expose the high fees you may be paying on your investments. Fewer investors care about getting whacked with fees amounting to, say, 2 percent annually when they’re making 20 percent yearly. But after a few years of low or negative returns, such high fees become quite painful and more obvious.

Avoid growth stocks if you get queasy easily

In a sustained stock market slide (bear market), the stocks that get clobbered the most tend to be the ones that were most overpriced from the period of the previous market rise (bull market). Like fads such as hula hoops, Cabbage Patch Kids, and Beanie Babies, in each bull market, particular types of growth stocks, such as Internet companies or biotechnology companies, can be especially hot.

Predicting the duration and magnitude of a bear market is nearly impossible. Consequently, it makes sense to focus your stock investing on those stocks that produce solid long-term returns and that tend to decline less in major market declines. For instance, so-called value stocks tend to be among the safer types of stocks to hold during a bear market. Value stocks generally have less downside risk because they have relatively greater underlying asset values in comparison to their stock valuations. (Value stocks also typically pay higher dividends.)

Tune out negative, hyped media

When the stock market is crumbling, subjecting yourself to a daily diet of bad news and conflicting opinions about what to do next makes most investors do the wrong things. Just like a steady diet of junk food is bad for your physical health, a continuous stream of negative, hyped news is bad for your financial health. Dwelling on bad news doesn’t do such great things for people’s emotional health, either.

The economy goes through periods of expansion and occasional periods of decline (with the former generally being longer and stronger than the latter). Conflict is always occurring somewhere in the world. The business world will always have some unethical and corrupt company executives. Holding stocks always carries risk. So those who see the glass as half full and who see the positive and not just the negative build wealth by holding stocks, real estate, and small business over the long term.

Ignore large point declines but consider the percentages

Look at an index’s percentage decline rather than at its point decline. Although 200 to 300 points sounds like a horrendous drop, such a drop amounts to a move of about 1 to 1.5 percent for an index trading around 18,000. No one likes losing that portion of their wealth invested in stocks in one day, but the percentage of change sounds less horrifying than the point change.

Don’t believe you need a rich dad to be a successful investor

Plenty of people who have come from non-wealthy families and have built substantial wealth by living within their means and investing in three wealth-building assets: stocks, real estate, and small business.

Mutual funds and exchange-traded funds are tailor-made for non-wealthy people who don’t have the assets to properly create a diversified portfolio themselves.

The best way to reduce the risk of investing in stocks is to diversify your holdings not only in a variety of stocks — which is precisely what good stock mutual funds do — but also in other investments that don’t move in tandem with the stock market (such as bond funds).

Understand the financial markets

When the going gets tough in the stock market, you can easily lose perspective and start making rash decisions. Instead, you must have the long-term perspective you need to succeed with stock investing, and you really need to understand how the financial markets work.

Talk to people who care about you

Life’s challenging events can be humbling and sometimes depressing. Holding an investment that’s dropped a lot in value — whether it’s a stock, a mutual fund, real estate, or a small business — is one such event. But you don’t have to carry the burden yourself. Talk about your feelings with someone who understands and cares about you. Be clear about and communicate what you’re seeking — empathy, good listening, a sounding board, or advice.