Given the historical record and what we know about behavioral finance, here are six steps for coping with a declining or volatile market:
1. Stay calm. Don't fall into the trap of selling low and buying high. Right now, any losses in your investment portfolio are only paper losses. They only become realized losses if you actually sell your holdings now - when prices are demonstrably low. In short, steer clear of the "buy high, sell low" wasteland - particularly if you still believe that all of your investments are solid choices for your portfolio and continue to fit your long-term strategy.
2. Stay focused on the long-term, not on short-term setbacks. Investing is a long-haul endeavor. The goal isn't to make money overnight, but rather to take advantage of the stock market's historical upward trend, and the beneficial effects of compound growth. If your long-term investment goals haven't changed and your investment strategy is properly aligned with those goals, you'll likely want to stay the course.
3. Check to see if your risk tolerance has changed. What may merit revamping your portfolio is a change in your tolerance for risk due to changes in your circumstances. (Take our risk tolerance quiz) Let's say you established your investment strategy when you were 30, just when you had begun saving in earnest for retirement. Now you're 55, and you haven't revisited your investment plan in all that time. (Not good practice, but it happens.) Given that you're now closer to retiring, you may legitimately want to adopt a more conservative investment strategy.
You may want to tread cautiously if you simply feel you no longer have the stomach you once did for wild swings in the market. If you literally can't sleep at night, you may wish to adopt a more conservative stance. But make measured, responsible changes. If 80% of your portfolio is invested in stocks today, maybe you reduce that to 70% - and revisit the issue again in six months.
4. Use diversification as a shock absorber. This advice is as timeless as your grandmother's words of wisdom: Don't put all of your eggs in one basket. At a high level, diversifying your investment portfolio means investing not just in stocks, nor just in bonds, but in a mix of both. Why? Stocks and bonds seldom move in lockstep.
With a diversified portfolio, losses in one asset class can often be offset by gains-or at least less severe losses-in the other. This smooths out your returns and makes it less likely that you'll panic when one market or another turns down. (Diversification does not guarantee you won't sustain losses.) But diversification is important within asset classes, too. If your stock portfolio consists only of large-company stocks like those in the S&P 500, for example, or if you've taken the opposite approach and invested only in small-company stocks, consider diversifying into both. Also consider owning a mix of growth and value stocks, and domestic and international stocks.
To sidestep the time and effort required to build and manage a broadly diversified portfolio on your own, consider investing in an asset allocation fund-a mutual fund that invests in multiple asset classes. Asset allocation funds make it easy and cost-effective to achieve broad diversification by investing in a single professionally managed fund consistent with your goals and tolerance for risk. (See: Asset Allocation Funds Can Help Tame Volatility)
5. Rather than focusing on gloom and doom, ask yourself if this is a buying opportunity. Think of the recent downturn this way: The stock market is on sale, with prices discounted significantly from the recent market peak. To be clear, the market could always fall further. But if you really are invested for the long haul, you might want to ask yourself if this is an opportune time to add to the stock funds in your portfolio rather than to reduce your equity holdings.
One way to take advantage of market dips automatically is by employing an investment strategy known as dollar cost averaging, in which you buy the same dollar amount of a specific investment, such as a mutual fund, at regular intervals. This is essentially what anyone contributing to a 401(k) plan at work, via payroll deduction, is doing. It ensures that your static contributions buy more shares when prices are low, and less when prices are high. (See: Don't Fear Volatility - Capitalize on It Through Dollar Cost Averaging)
6. If you're investing in a taxable account, consider tax-loss harvesting. In the spirit of making lemonade out of lemons, consider selling any holdings that might be worth less now than what you paid for them. Those losses can be used to offset gains in other parts of your portfolio - now, or potentially in later years. This is a complex strategy with a number of nuances that can impact its application, however, so you may want to consult a tax advisor before acting.
Watching the stock market tumble is never fun. But enduring market volatility is part of investing. Staying patient and prudent - rather than panicking - is almost always the right course of action.