The worst of the Monday stock market sell-off saw the Nasdaq Composite down more than 15% year-to-date (YTD), and the S&P 500 enter correction territory, down over 10% YTD. Although the market staged a staggering comeback with both indexes finishing up for the day, Tuesday brought further losses, and no one knows how much further markets could fall over the short term.
In times like these, it's best to prepare for the worst so you aren't left blindsided if it does happen. Here are three questions you should ask yourself so you can take the necessary course of action if there's more pain ahead.
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1. Do you have an emergency fund?
When share prices of companies you want to buy are trading at a steep discount, it can be tempting to throw every cent you own and buy the dip. But doing so not only wipes out dry powder you may need for later dips, but it can also be risky to your overall financial health.
Throughout market sell-offs or challenging economic times, it's a good practice to make sure your emergency fund is intact. An emergency fund is a reserve of cash held in a checking or savings account large enough to cover expenses for a period of time. Some schools of thought suggest an emergency fund should be large enough to replace three to six months of income, which is an ambitious but safe approach.
An emergency fund can come in handy if you face unexpected expenses of any kind. Instead of having to sell stocks at bargain prices or sell your prized baseball card collection, you can simply tap into your liquid emergency fund to cover the expense.
2. Do you believe in the stocks you own?
Knowing what you own and why you own it is a practice that often gets forgotten about when the market is roaring higher. When times are good, it's easy to buy something on little more than speculation and hope. But when valuations are plummeting, you can often find yourself wondering what a business even does and why you own it in the first place.
Going through your portfolio of stocks and other securities and investment vehicles not only ensures your hard-earned savings are in assets you want to own, it also gives an investor a sense of control and clarity over their larger financial picture.
3. How will you react if the market keeps falling?
Investing in the U.S. stock market continues to be one of the best ways to compound wealth over time. But that advantage is quickly lost if an investor panic-sells at the wrong time.
The emotional side of investing is more important than we often give it credit for. Making a game plan for how you'll react and the moves you'll make if the market falls 10%, 25%, or even 50% reduces randomness and the risk of making an impulse decision you might regret.
We're all human. When we get scared or feel trapped, the instinct is to act -- the old fight-or-flight adage. History tells us it is better to do nothing. If you had bought an S&P 500 index fund on Oct. 9, 2007, right at the market peak before the downturn, and sold it at the worst time of the financial crisis on March 9, 2009, you would have lost 57% of your money. If you had simply held and done nothing, even though you bought at the worst time before the crisis, you would have more than doubled your money by the end of 2021.
The price of admission
No one likes losing money. No matter how hard we prepare for a downturn, a sea of red with no end in sight is a difficult thing to stomach. Enduring through market downturns is the highest price an investor must pay if they want to benefit from the long-term gains of the U.S. stock market. Volatility is simply par for the course. Once you understand the "price of admission" required to play the game that is the U.S. stock market, you will likely stand a better chance to stay even-keeled when faced with adversity.
