Investors are worried about a stock market crash, and they're trying to figure out how to weather the storm. The S&P 500 is down more than 10% so far this year, and more trouble ahead seems likely. The obvious reaction is to sell stocks and prevent further losses, but that might not be the wisest decision. Here's why.
The market is risky right now
The Federal Reserve took an aggressive stance on its tapering timeline in recent months. Historically, stocks have struggled when the central bank pulled back on monetary stimulus. Higher rates reduce investors' risk appetite, and economic activity tends to slow with higher cost of capital. This is no guarantee that this correction will turn into a bear market, but a major catalyst has been removed.
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Stock valuations aren't helping the situation. Right now, equity prices are high relative to sales, earnings, cash flow, book value, and dividends. This isn't the case for every stock, but it is so for the market in general.
That's especially true for index funds. Major indexes are currently dominated by large-cap tech stocks, and they have higher valuation ratios than companies from other sectors. Expensive valuations assume high growth, and it creates more risk for investors. If growth falls short of expectations, a correction is almost certain.
S&P 500 Shiller CAPE Ratio data by YCharts
There's evidence that economic expansion could have a strong couple of years, but it's far from guaranteed. Unemployment remains high as workers navigate a new world following all the business closures and relocations that occurred during the pandemic. Global supply chains have been disrupted or permanently changed. Inflation is creating uncertainty across the board. Hopes for the immediate recovery from the COVID-19 crisis have been dashed, which makes it harder to justify aggressive valuations in most of the stock market.
All of this considered, the current market downturn isn't shocking. These problems still haven't been sorted out, so there's probably more turbulence ahead.
That's still not a good reason to pull your money
Most investors shouldn't be selling their stocks right now, despite the risks. It might seem counterintuitive, but there's a ton of historical evidence that supports a steady-handed approach through a market downturn.
Volatility and cycles are natural characteristics of the stock market. Investing in equities is a great way to build wealth over the long term as businesses grow. To achieve those gains, however, you have to deal with the short-term consequences of supply and demand. You can't reasonably expect to enjoy all the good times without enduring some of the bad times along the way. History shows us that good times outnumber the bad over the long term.
That's not much consolation for investors who are watching their net worth erode every day in the market. It's tempting to panic and sell stocks to prevent losses. If you sold all your stocks today, you probably would avoid further losses as interest rates rise and stock valuations normalize. However, you'd open the door for opportunity cost. Potentially missing out on future gains could be way worse than riding out some temporary losses this year.
When stocks are sold to avoid losses, that capital has to be redeployed somewhere else. Sellers attempt to wait out a market crash and then repurchase stocks before they resume growth. That plan makes sense on paper, but it's almost impossible to execute. Very few people can successfully identify market tops and bottoms. In the past, many of the market's best days occurred shortly after some of the worst days. That doesn't leave much room for error.
If you bail out during corrections, you'll probably miss out on growth. Investors might take a beating over the next few months, but that could be followed by strong returns later in the year. That's exactly what happened in 2009 and 2020. For most investors, the best strategy is to buy good stocks based on their business fundamentals and hold on to them long term.
Review your portfolio allocation
It's a bad idea to panic and quit the stock market right now. However, it's a great idea to make sure that your portfolio allocation reflects your risk tolerance. The market will probably remain volatile this year. Investors with short time horizons need to make sure that they have the right balance of growth stocks, value stocks, and bonds.
If your risk tolerance is low, it could be a good idea to reduce the amount of growth stocks -- or stocks in general -- in your investment portfolio. A risk tolerance questionnaire is a great place to start. The best investors develop a long-term strategy that's designed to perform across entire market cycles with modest adjustments as conditions change. That's a much better plan than drastic course alterations during predictable corrections.
