We all make mistakes. It's part of the human experience. The best you can do is learn from them and try not to make them in the future. Some are even able to learn from others' mistakes. But it's rare. As anyone with teenage kids -- or who remembers being a teenager themselves -- knows, you can share what you've learned but people typically have to make mistakes for themselves to get the message.
With that caveat, I'll share three things that you absolutely should not do if the stock market crashes. These lessons have proven true over time. But like most people, I had to learn them myself over the last quarter century of investing. Hopefully, you can learn from my mistakes.
1. Don't ignore the business
When you own a small portion of a business -- that's what shares are -- it's easy to get distracted by the stock price. After all, we don't have much more to judge the company by until the next quarterly earnings report. But that isn't what the company's employees are paying attention to. They are focused on the processes and metrics that indicate how happy customers are, how productive teams are, and how money is flowing through the business.
That's why it's important to stay focused on the real world if the stock market crashes. Go visit a company location if you can. Are there fewer customers? Is the staff concerned? Does it look like it is worth less than the last time you visited?
Good examples from the recent pandemic-induced crash are Microsoft (MSFT -0.18%) and AMC Entertainment (AMC 13.00%). While both saw their stock prices drop precipitously in the spring of 2020, the businesses were performing much differently.
2. Don't panic sell
In investing, emotions play an outsized role. And they are our worst enemy. Although there have been questions about whether the study actually exists, Fidelity supposedly found that its most successful customers were either dead or had forgotten they had an account. A study from the University of California, Davis and the University of California, Berkeley found that trading reduced investors' returns. That underperformance was attributed to costs -- an expense that (mostly) no longer exists for current investors.
Still, emotion can lead to poor outcomes. Warren Buffett's famous quote from the 1986 Berkshire Hathaway (BRK.A -0.67%) (BRK.B -0.87%) shareholder letter turns the risk of reacting the way everyone else does on its head:
"We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
There are a few ways to combat the knee-jerk reaction to sell when the market sinks. You could make a pact with your spouse or significant other to explain any stock sale before you do it. Keeping an investing journal is a good way to do this for yourself. Wanting to avoid losses is natural, but it typically results in underperformance.
Another way to keep calm is to understand the companies you own. Reading earnings reports, listening to conference calls, and being able to articulate exactly how the company makes money can give you a lot of confidence to hold (or buy more) when others lose their cool.
If you don't want to do the work to understand individual companies, you can always buy an index fund or ETF that mirrors the overall stock market. The SPDR S&P 500 ETF Trust (NYSEMKT:SPY) or Vanguard S&P 500 ETF(NYSEMKT:VOO) are good low-cost options.
Besides, market crashes usually don't last that long. Before last year, there had been 13 stock market corrections since World War II. That means the index declined at least 10%. Averaging them, it only took four months for the market to recover. Even last year, what looked like a potential depression quickly turned into a bull market as stimulus checks hit consumers' bank accounts and Moderna and Pfizer delivered a vaccine for COVID-19.
3. Don't stop investing
Want one simple way to avoid making those emotional mistakes? Keep investing. Many people hear the term "dollar-cost averaging" and think about buying more shares of a company they own when the stock is down. That's one way to do it. Another is to continuously buy shares no matter what is happening in the market or the world at large.
This is why retirement accounts like a 401(k) can be so powerful. Saving money out of every paycheck ensures that you are putting money to work even when stocks are crashing. The same goes for other tax-advantaged accounts or taxable brokerage accounts.
Whether you buy individual stocks or mirror the index, consistent buying is a recipe for wealth creation. Just look at the drawdowns you would have had to endure with the S&P 500 index or Disney (DIS 0.74%) over time. Through all of that noise, they have generated 1,610% and 1,460%, respectively, including dividends. Investors who skipped the dips didn't realize that same performance.
Learn from others' investing mistakes
It's easy to write about the mistakes investors make, and even easier to read about them. But putting these lessons to work will take planning, discipline, and a little help. That said, paying more attention to the business than the stock price, checking your emotions, and sticking to your plan might be the three most important steps in building wealth over time.
After twenty-five years of investing, I've come to accept that everyone will probably have to learn these lessons for themselves. But do yourself a favor and bookmark this article or one like it. And reread it the next time the market has a serious drop.