Avoiding Panic Selling in a Declining Stock Market – February 25, 2016
Citrin Cooperman & Company
Description
Feb 25, 2016
Avoiding Panic Selling in a Declining Stock Market
As seen in The Legal Intelligencer
With memories of the 2008-09 market crash still fresh in the minds of many investors, the stock market got off to a miserable start as 2016 got under way. The
selling started on the first trading day of the New Year and continued largely unabated throughout the rest of January. The S&P 500 Index lost 5.1 percent for the
month, which was the worst start to a new year since 2009.
As is usually the case, the sharp declines in the market set off a crescendo of scary predictions about what was going to happen next. Most of the dire
predictions centered on the worldwide collapse in the price of oil and many other commodities.
Perhaps nothing threatens the well-being of equity prices as much as the prospects for a deflationary cycle. Much of the inherent confidence investors have in the ability of equity prices to rise over time is rooted in the expectation that, in the long run, inflation increases stock values. If nothing else, expectations of inflation make equities significantly more attractive in comparison to investments in fixed-income securities. Worries about the direction of stock prices end up seeping into an investor's psyche whenever the market declines significantly.
A market correction, defined as a decline in price of more than 10 percent, is not uncommon. A bear market, which occurs when stocks decline in value by 20 percent, is less common. Since the end of World War II, there have been 34 corrections but only 12 bear markets.
During those instances when a correction does not escalate into a bear market, the sell-off, while frequently violent, tends to run out of steam in a relatively short period of time. In those cases, investors who refrained from selling equities were rewarded for their perseverance. Even greater were the rewards for those who had the courage to "buy the dips" during the sell-off. Between October 2007 and March 2009, however, in the midst of the subprime mortgage crisis, the S&P 500 Index fell by more than 56 percent.
Holding firm to an allocation of stocks during a sell-off of that magnitude required uncommon inner strength. Anyone who bought the dips, particularly during the earlier stages of the decline, had an even more difficult time hanging on as the market went even lower. Yet, at a moment of maximum pessimism the broad equity markets bottomed suddenly, and the recovery from that point was quite rapid.
Imagine the dilemma faced by an investor who, in the face of bruising portfolio losses, converted equities into cash at a time relatively close to the market bottom. No one wants to get caught liquidating stocks under duress just before the market recovers. In what circumstances is an investor best equipped to avoid panic selling? The answer is obvious and it is standard advice offered by virtually all investment advisers. Given the market's recent behavior, however, and in light of worries about global deflation, some reiteration of the obvious is probably in order. The key to avoiding untimely selling is to own an appropriate and diversified allocation of equities, and to have a time horizon of suitable duration.
It is not only a question of the percentage of total investment assets being allocated to stocks, but the composition of those stocks that can turn out to be of vital importance. One has only to look at the dot-com bubble in March 2000 to appreciate what can happen to someone who is speculating in stocks that rely strictly on price momentum to move higher. Proper allocation is the best way to avoid making errors in judgment that can have devastating effects on one's financial well-being. In deciding on an allocation, an investor's tolerance for risk must be realistically assessed. There are many questionnaires and online tools designed to help make such an assessment.
While useful, orderly responses to questions in advance of a crisis may not be sufficient to predict how an investor will stand up to a sharp sell-off. The assessment is easier in the case of an experienced investor who has lived through prior bear markets or periods of extreme volatility. That is not to suggest that a seasoned investor is above making mistakes.
After all, bear markets are by no means identically constructed. Age is obviously a very important factor. Risk tolerance normally declines as an investment time horizon becomes shorter, as there are simply fewer years left in which to recover losses. On the other hand, for a younger investor, particularly one who has a reliable future income stream, the length of time it takes to recover investment losses is less important.
It is much easier in this case for an investor to have the confidence to add fresh money to equities as markets fall. This is commonly referred to as dollar-cost averaging. One of the most efficient ways to buy stocks in this scenario is through a program of dividend reinvestment. When the market goes through a downturn like the present one, even an experienced investor is prone to panic selling.
The fact is that no one can be certain when a declining market will hit bottom, or how quickly it will rebound. We do know that there is a natural tendency on the part of many investors to buy stocks when the prices are high and sell when the prices are low. A thoughtful and realistic allocation is the best antidote. Reprinted with permission from the February 25, 2016 issue of The Legal Intelligencer.
© 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved. © CITRIN COOPERMAN & COMPANY, LLP CONNECTICUT | MARYLAND | NEW JERSEY | NEW YORK | PENNSYLVANIA | CAYMAN .
Perhaps nothing threatens the well-being of equity prices as much as the prospects for a deflationary cycle. Much of the inherent confidence investors have in the ability of equity prices to rise over time is rooted in the expectation that, in the long run, inflation increases stock values. If nothing else, expectations of inflation make equities significantly more attractive in comparison to investments in fixed-income securities. Worries about the direction of stock prices end up seeping into an investor's psyche whenever the market declines significantly.
A market correction, defined as a decline in price of more than 10 percent, is not uncommon. A bear market, which occurs when stocks decline in value by 20 percent, is less common. Since the end of World War II, there have been 34 corrections but only 12 bear markets.
During those instances when a correction does not escalate into a bear market, the sell-off, while frequently violent, tends to run out of steam in a relatively short period of time. In those cases, investors who refrained from selling equities were rewarded for their perseverance. Even greater were the rewards for those who had the courage to "buy the dips" during the sell-off. Between October 2007 and March 2009, however, in the midst of the subprime mortgage crisis, the S&P 500 Index fell by more than 56 percent.
Holding firm to an allocation of stocks during a sell-off of that magnitude required uncommon inner strength. Anyone who bought the dips, particularly during the earlier stages of the decline, had an even more difficult time hanging on as the market went even lower. Yet, at a moment of maximum pessimism the broad equity markets bottomed suddenly, and the recovery from that point was quite rapid.
Imagine the dilemma faced by an investor who, in the face of bruising portfolio losses, converted equities into cash at a time relatively close to the market bottom. No one wants to get caught liquidating stocks under duress just before the market recovers. In what circumstances is an investor best equipped to avoid panic selling? The answer is obvious and it is standard advice offered by virtually all investment advisers. Given the market's recent behavior, however, and in light of worries about global deflation, some reiteration of the obvious is probably in order. The key to avoiding untimely selling is to own an appropriate and diversified allocation of equities, and to have a time horizon of suitable duration.
It is not only a question of the percentage of total investment assets being allocated to stocks, but the composition of those stocks that can turn out to be of vital importance. One has only to look at the dot-com bubble in March 2000 to appreciate what can happen to someone who is speculating in stocks that rely strictly on price momentum to move higher. Proper allocation is the best way to avoid making errors in judgment that can have devastating effects on one's financial well-being. In deciding on an allocation, an investor's tolerance for risk must be realistically assessed. There are many questionnaires and online tools designed to help make such an assessment.
While useful, orderly responses to questions in advance of a crisis may not be sufficient to predict how an investor will stand up to a sharp sell-off. The assessment is easier in the case of an experienced investor who has lived through prior bear markets or periods of extreme volatility. That is not to suggest that a seasoned investor is above making mistakes.
After all, bear markets are by no means identically constructed. Age is obviously a very important factor. Risk tolerance normally declines as an investment time horizon becomes shorter, as there are simply fewer years left in which to recover losses. On the other hand, for a younger investor, particularly one who has a reliable future income stream, the length of time it takes to recover investment losses is less important.
It is much easier in this case for an investor to have the confidence to add fresh money to equities as markets fall. This is commonly referred to as dollar-cost averaging. One of the most efficient ways to buy stocks in this scenario is through a program of dividend reinvestment. When the market goes through a downturn like the present one, even an experienced investor is prone to panic selling.
The fact is that no one can be certain when a declining market will hit bottom, or how quickly it will rebound. We do know that there is a natural tendency on the part of many investors to buy stocks when the prices are high and sell when the prices are low. A thoughtful and realistic allocation is the best antidote. Reprinted with permission from the February 25, 2016 issue of The Legal Intelligencer.
© 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved. © CITRIN COOPERMAN & COMPANY, LLP CONNECTICUT | MARYLAND | NEW JERSEY | NEW YORK | PENNSYLVANIA | CAYMAN .
