October has historically been a spooky month for the markets. Almost as if haunted by the October crashes of 1929 and 1987, they seem to fall prey to gremlins and their scary gyrations in the weeks leading up to Halloween. Last Friday's dramatic 367-point drop was just the most recent in a long, stomach-churning line of autumnal market frights.
Of course, market drops can be scary no matter the season. But what's scarier still is how many people react to them.
Fleeing in panic
Big market drops are nearly always accompanied by lots of selling by individual investors. As I've noted before, there are two major reasons for this:
- The speed of the market's drops. Markets tend to march upward slowly and then "correct" (read: "plummet") in big downward falls. The speed of these falls, when contrasted with the slower upward movements, can make a one-day plunge feel like the beginning of a long and devastating downturn.
- Loss aversion. That's the name psychologists and researchers give to the human tendency to hate losses more than they like gains. The difference can be twice as much in favor of dreading the losses, according to numerous studies.
Put those two things together, and it's easy to see -- and feel, if you've been there -- how your brain and gut can get spooked by a big market dive and push you to sell. Losses hurt, and the specter of more losses to come hurts even more. We're wired to avoid pain, so we sell. I've done it, and I know lots of others -- including plenty of professional investment managers -- who have done it at least once or twice.
We all know that the market goes up and down. That's its nature. On balance, over the long term, it tends to go up more than down, but sometimes those down periods are downright (so to speak) ugly. But here's the thing: Those ugly periods don't actually hit your portfolio unless you sell during one. If you sell in the wake a market drop, you lock in that drop. You own it. And the temptation to make that trade can be enormous.
But if you hold on, then the market drop becomes just one more period of volatility your portfolio went through on the way to your eventual goal -- and if you can keep your cool and have cash available, then buying during corrections can be a great way to juice your returns.
How to be a ghostbuster
Surviving spooky market drops is mostly about understanding the temptation to sell out in a panic and not giving in to it. While you're resisting temptation -- or channeling that temptation toward the Halloween candy instead -- keep these thoughts in mind:
- The overall market will recover. It always has, and often it turns on a dime and shoots right back up to pre-correction levels. If you sell out, you may well miss that turnaround. How will you feel then?
- Resist the urge to time the market. Along similar lines, don't fool yourself into thinking that you can "see" a drop coming and sell out in advance. Remember the old joke about the economist who had predicted 18 of the past four recessions? Many who try to time market drops end up being the butts of similar jokes. If that's not enough to persuade you to think twice, remember that successful market timing also involves knowing when to get back into the market. Do you trust your timing skills -- or your luck -- that much?
- Consider re-evaluating your holdings. Are you really comfortable holding your portfolio through times of market volatility? It's easy to convince yourself that you have a high risk tolerance -- and load up on volatile small caps -- when the market is in a smooth bullish phase. But if your portfolio's gyrations are keeping you up at night, it's time to reconsider.
One last note: Reconsidering your holdings doesn't have to mean selling everything and buying bonds. But you may want to reorient your portfolio away from get-rich-or-broke-quick small caps in favor of stocks that are more likely to hold their ground when the goblins come out, yet still give you exposure to the market's upside. I'm a fan of big dividend-payers, and good ones, such as health-care giant Johnson & Johnson
Fool contributor John Rosevear does not own any of the stocks mentioned in this article. Johnson & Johnson and William Wrigley are Income Investor recommendations. The Motley Fool has a disclosure policy.