Thanks in part to high inflation and the risk of stagflation, it has been tough to invest in stocks so far this year. Still, most tough markets bring with them the seeds for the next recovery, and chances are that this one will, too.
The challenge, though, is that by the time investors recognize they are firmly in the middle of the next recovery, much of the early and outsize returns may have already been made. Therefore, it's important to be willing and able to stay invested even as the market is crashing. That's easier said than done, but there are four steps you can take to help prepare yourself and your portfolio to enable you to stay invested even in a rough market.
1. Have a long-term perspective
Investing in stocks is best done if you have a long-term time horizon. As Benjamin Graham -- the guy who taught investing to Warren Buffett -- once said, "In the short run, the market is a voting machine, but in the long run it is a weighing machine." In other words, while the market can wildly move up or down in any given day, over the long haul, a stock's performance is ultimately tied to the underlying business's performance and prospects.
In that framework, it's important to recognize that while the market should eventually reflect the true value of an underlying company, it may take quite a while to get there. As a result, you need both enough patience to wait for that long term to be realized and enough of an objective perspective to be able to estimate what that fair value looks like.
2. Make sure your own financial house is in order
It is much easier to have the patience to wait for the long term if your finances are able to handle that wait. For instance, if you expect you'll need your money within the next five or so years, it does not belong in stocks. The reason is simple: If you have to liquidate your stocks to meet a near-term expense, that money simply can't wait for a market recovery.
Beyond that cold, hard truth, even if you could delay an expense because of a rough market, if you see a risk to your lifestyle driven by a downward-pointing stock market, it likely will affect your thinking. It's easy to get tricked into believing you have to sell before things go from bad to worse, when in fact, stocks might really be getting cheap enough to buy hand over fist.
3. Have a good estimate of the value of the stocks you're considering
To recognize when a stock is getting cheap, you first have to be able to get a handle on what the company behind that stock is really worth. A tool like the discounted cash flow model can help you calculate that intrinsic value.
To use it, in essence, you start by estimating the amount of money the business will generate in the future. Then, you look at when it will earn that money and dial back (or "discount") it based on how far out in the future it will earn the money and how risky those projections are. Finally, you add up all those discounted future earnings, and the result is your best estimate of what the company is worth.
The upside of that approach is that it can give you a fundamentals- and operations-based way to understand the value of a business. The downside of it is that your guess is at least as good as mine as to what the future will really bring for the business. By the time that future plays itself out, much of the real returns will have already been made or lost based on what actually happens. In reality, nobody gets it perfect 100% of the time.
4. Recognize the risks of being wrong, and diversify appropriately
Because nobody gets it correct all the time, it's important to manage your investments with at least an eye toward diversification. Done right, diversification can minimize the impact to your overall portfolio from the failure of any one of your investments. That way, even though you will get it wrong from time to time, overall you can end up just fine as the long-term returns in your successes can overwhelm the losses from the ones that don't work out.
The key to smart diversification, though, is to make sure that every investment you buy is one you're willing to own on its own merits, and not just a pick to fill a diversification need. That way, even as you're spreading your risks out across multiple industries, each investment you're making has a legitimate shot of delivering the returns you need it to.
Put it all together, and you have a plan that's easier to stick with
These four steps make it much easier to navigate through a rough market and improve your chances of making the right decisions for your long-term financial health. They won't keep you from seeing your portfolio fall when the market is rough, but they can help you keep your head on straight during the crisis. That can help you make the smart decisions when things look their worst to come out the other side in a better spot than you otherwise would have.
The market's recent swoon shows how important it is to have a solid strategy in place to stay invested when things get rough. So if you don't have your own plan in place yet, now is a great time to get started. If there's another leg down in the market, you'll be glad you did. And if the worst is really behind us, you'll still likely find that with the right foundation and plan in place, you'll be able to make better long-term financial decisions.