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Why Fear is Your Friend in This Market Downturn

By Divyansh Awasthi – Updated Jun 26, 2020 at 12:44PM

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There is fear all around financial markets. But you can turn it into an ally for the sake of your portfolio.

"The only thing we have to fear is fear itself." Franklin D. Roosevelt made this famous statement during his inauguration in March 1933. The context, though different, applies aptly to financial markets today. Anyone who has sacrificed spending their hard-earned money in favor of making an investment knows this fear. And it is a difficult one to overcome.

Unfortunately, it does not end once you make the investment. It seems that every time the market dips, your heart skips a beat. This happens because of the fears of seeing your profits decline or losing a portion of your invested money. But not all fear is bad. The fear prevailing across markets right now can be your ally.

But first, let's look at why, as an investor, fear is generally considered your enemy.

A man is visibly scared, with his hand on his forehead. Behind him, a line graph is dropping.

Image source: Getty Images.

The downside of being afraid as an investor

We will use the stock market as our instrument for assessing fear. Healthy returns are the most attractive feature of stock investing. But big returns come with big risks, including that of losing your invested capital. It is these risks that generate fear in your mind. When you're afraid, it's much easier to avoid an experience rather than overcome the fear. In this way, fear can hinder the potential growth of your investment portfolio.

We don't need to venture deep into history to see an example of this. Individuals who had started earning in the mid-2000s had to witness a recession very early in their careers. With comparatively lower disposable incomes, it was easy for young workers to avoid stocks due to the fear of losing their capital. However, those who were able to overcome it would have made handsome gains. An investment of $10,000 in mid-June 2008 made in the S&P 500 and left as-is would have resulted in nearly $23,000 today, fueled by a compounded annual growth rate of 7.2% over the 12 year period. And this is even without considering dividends over the timeframe!

The ride would have been tough, and it would have been easier to simply avoid stocks because of the fear surrounding their future. But the result would have been money lying in a bank account with extremely stunted growth. Even if we consider the maximum national rate cap for savings accounts published by the FDIC -- an average of 0.85% -- money sitting in a savings account for that same 12 year period would have grown to only $11,000!

What the absence of fear does to judgement

Let's look at the other side of the argument -- the absence of fear. Before the coronavirus pandemic hit, US stock markets were on a tear. You could make money in almost any segment in the market and via any instrument: direct equities, mutual funds, or ETFs. While this sounds great, there is a major risk that lurks in the background -- excessive exuberance.

When there is money to be made almost anywhere in stocks, there is little reason to exercise caution. But this exuberance comes at the cost of good judgement. A rise in markets can make you feel invincible. You may harbor a false sense of security about your ability to select the right stock or fund.

But all exuberance fades quickly when markets face adversity. This point leads to our present situation.

You have a new friend request -- it's Fear!

A sharp decline in stocks leads to a simultaneous rise in fear. We also have a measure for it. The volatility index, or the VIX, calculated by the Chicago Board Options Exchange, is popularly known as the 'fear' index. The higher its reading, the more afraid people are about investing in stocks. At the end of 2019, the VIX stood at 13.8. As the coronavirus pandemic spread, it surged to 82.7 in mid-March. And though it has declined from that peak, it still stands at 33.6 as of June 25. That indicates significant fear.

So let's turn this fear into our friend.

  • Fear of the unknown can compel us to grow our knowledge. Our situation can quickly be improved by conducting a portfolio review. Take a careful look at your holdings. How many stocks are you invested in? Are they accounting for too much of your invested capital? This can usually be the case when you're just coming out of a rising stock market. This will also explain why your portfolio may be beaten down right now. Given the state of markets, you may not be able to sell some of your holdings immediately. But the fact that you know what you hold will empower you to take decisive action when your holdings start performing better. You'll no longer be in the dark about what to do.

  • A careful portfolio review will also set you up well for another important action: portfolio diversification. Let's take an example. The review may tell you that banks form a sizable portion of your stock holdings. Banking stocks have been hit hard in 2020 so far. This means your portfolio would be down drastically. So your plan of action is to diversify your holdings across sectors. Add some technology stocks to the mix. Throw in some companies from the healthcare sector. The idea is to spread your money across sectors and industries. This helps to spread your risk as well.

  • Also, do not hesitate to seek professional help to better understand your investment options. You may not have considered this when markets were soaring pre-pandemic, but the fear created by present circumstances will help you see the value in outside help.

Once we are out of this market downturn, you'll find that overcoming and befriending fear was your biggest gain from these trying times because of the knowledge it forced you to gather. I hope you accept Fear's friend request.

Divyansh Awasthi has no position in any of the stocks mentioned. The Motley Fool recommends Cboe Global Markets Inc. The Motley Fool has a disclosure policy.

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