If the headlines have you worried about a stock market crash, make sure that you're prepared for it. Market crashes are out of your control, but you can compound your losses by making bad decisions. Avoid these three common reactions to navigate the next bear market and set yourself up for long-term gains.
1. Don't panic
Volatility is an inevitable part of even the best stock market investment plan. It's assumed that bear markets will drive account values lower at some point. That might sound crazy, but stock market crashes aren't a new phenomenon. Corrections and crashes happen periodically, and they are temporary diversions from an overall upward long-term trend in stock prices. Professional investors and advisors recognize this and design their strategies with this expectation.
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That knowledge might not ease the pain of investment losses, but it's important to keep in mind. You can't let emotional reactions dictate financial decisions -- emotions fade over time, but investment theory is based on decades of quantitative observations. If you develop a portfolio allocation that's based on established investment principles, then you shouldn't tear up that plan when a predictable short-term issue arises.
In the history of the stock market, there has never been a 16-year period with negative returns for the S&P 500. There have been very few 10-year windows with negative returns, and the average annual return hovers around 8%. These results include every market crash and recession that's occurred previously. The stock market tends to rise with the global economy over the long term, so investors can be confident that their accounts will rebound and grow again in the future.
If the market crashes, focus on the long term. Don't panic or make any emotion-fueled decisions. Make sure that you are still in a position to benefit from the inevitable recovery.
2. Don't sell your stocks
A market crash is among the worst times to sell your stocks. Instinctively, many people are conditioned to limit pain by stopping any activity that is causing pain. That encourages some investors to back away from a crashing stock market entirely to avoid any further losses.
Don't do that. It's an irrational, fear-based response that has the potential to completely sabotage your long-term performance.
If the market crashes, stocks very well might slide lower. It's hard to tell when the market has truly hit bottom. Once you accept that it's impossible to truly know what the future holds, it's important to think about probability and historical evidence. Some analysts talk about "asymmetric risk and reward," which refers to the relative balance of upside and downside potential. Crashes make stocks cheaper relative to companies' revenue, profits, cash flows, and dividends, resulting in a situation with lower downside risk and more upside potential for shareholders.
Selling stocks during a crash is a great way to transform temporary, unrealized losses into permanent, realized losses. It's a blatant violation of the "buy low, sell high" approach. You should stay the course when stocks get cheaper.
3. But also don't get too greedy
It's also important to avoid an excessively contrarian approach during a crash. It's easy to recognize that stocks have become cheaper and conclude that it's a good idea to lean even more heavily into growth equities. That might work out sometimes, but it's generally unwise to load up on excess risk.
As discussed above, it's nearly impossible to pinpoint the bottom of a crashing market. There's always a good chance that the market tumbles further, and that could have disastrous consequences for portfolios that are allocated too aggressively. Even if the losses stop, there's no telling how long the market will take to rebound -- it could be years before things turn around. You don't want to bet your nest egg on a quick recovery if you plan to recover in a few years.
It's OK to shift slightly toward a growth-heavy portfolio as market conditions evolve, but your allocation should always reflect your risk tolerance and investment time horizon.
