If you've checked your portfolio in 2022, you know that this year has been rough for stocks. Across the board, some of the best companies and most-followed indexes have seen their stock prices drop well into the 20% to 60% range, wiping away many of the gains they saw during the mid-2020/2021 bull market. Even though stock prices are declining, you'll want to resist these temptations at all costs.
1. Panic-selling
It's easy to see your investments dropping and want to sell them before they continue to drop, but that's usually not the best approach. Volatility and bear markets in the stock market are inevitable; they've always happened, and you can bet they will continue to happen in the future. If you understand this as an investor, you can prevent yourself from panicking when it happens. If you're focused on the long term -- which you should be -- and time is on your side, you have to be comfortable riding out the storm.
Panic-selling can also add insult to injury by triggering a tax bill. If you've held an investment for less than a year, you'll pay your regular income tax rate on any capital gains. If you've held it for more than a year, you'll get a special capital gains rate, but it's taxes and money owed nonetheless. You don't want to find yourself selling because prices are dropping and then owing taxes on top of that.
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2. Stopping investing
To me, keeping your eyes on the prize in investing means focusing on the long term and not letting short-term happenings trigger irrational decisions, such as stopping your investing. It's easy to want to stop investing when prices are continuously dropping. After all, why buy now when prices will be lower later? The problem is that you don't know how far prices will fall or if they'll suddenly rise again, and you don't want to find yourself trying to time the market.
As prices are dropping, you need to stick to your investing habits. If anything, view this as a chance to get some of your favorite investments at a "discount" and lower your cost basis. Lowering your cost basis now will increase your profit potential whenever you sell your stocks in the future. Instead of stopping investing, consider increasing it a bit if you have the means.
3. Focusing only on individual companies
One of the best ways to protect your portfolio during market downturns is to have diversification. It helps to diversify in industry, company size, and global location in your stocks. This is a tough task if you only invest in individual companies. You would have to research industries as a whole and then research the many companies within that industry to decide which investment makes the most sense for you. And it's even tougher when it comes to international companies because there are other factors you need to consider, like a country's economic and political stability.
The best way to achieve diversification is through index funds because they allow you to invest in numerous companies at once. There are index funds like the Russell 3000 that track the entire U.S. stock market, funds that focus on companies of a specific size, like the S&P 500, and funds that focus on specific sectors, like the Nasdaq Composite. Using a combination of index funds can ensure you get diversification in your portfolio.
4. Using emergency funds to buy the dip
It's common to hear people encouraging each other to buy the dip whenever stock prices are declining. Buying the dip can oftentimes pay off when (or if) stock prices begin to rise, but you want to make sure you're using the money you've already allocated to investing and not dipping into your emergency fund -- which should be at least three to six months worth of expenses -- because you see a "must-have" opportunity.
It's easy to think you can dip into your emergency fund and replace the money later, but there's also a chance an emergency will happen before you can do so. Hopefully, an emergency wouldn't happen, and you're able to replace the money, but that can set a bad precedence and should be avoided. Your emergency fund is for exactly that: emergencies. Investment opportunities may seem lucrative and too good to pass up, but they shouldn't put your emergency fund at risk.
