Surviving a Market Sell Off
Part of the job of a financial planner is helping clients to make money. But the flipside of that job is showing them how not to lose money. As everyone knows, it’s impossible to guarantee investment performance, but there are ways to minimize losses, particularly during a market sell off. The best way to do that is through advance preparation.
Here are 7 ways to survive a market sell off. This isn’t a prediction that a sell off is imminent, but only a series of steps that will help you prepare for one should it happen.
#1: Don’t let emotions get the best of you
Have you ever seen one of those National Geographic programs that shows herds of animals on the run? You could imagine that if the few animals leading to herd were to jump off a cliff, that the hundreds of animals behind would follow them right over the edge.
That’s something close to what happens during a market sell off. A few people panic, and sell off their stocks, causing an initial wave of market declines. Then the next wave of investors begins to sell in reaction to the first group, causing stocks to fall even farther. Before you know it, the sell off is feeding on itself, and prices are dropping as though there is no bottom to the market.
That’s how a panic works, mechanically. What makes it particularly difficult to react to is that it’s driven almost entirely by collective emotions, not by the fundamentals of the market. While there may have been some bad news that triggered the initial wave of selling, what happens afterward is mostly the result of fear.
You never want to let your own emotions take charge of your behavior during a market sell off. If you do, you can and up selling many of your stock positions at distressed prices, and buying them back at higher prices later. Following some of the other steps will help you to avoid the fear factor.
#2: Understand why the market is selling off
Market sell offs seldom follow predictable patterns. Though there could be a general market sell off, there are also the type that affect primarily certain market sectors. You have to determine if the sectors where you are heavily invested are at the center of the sell off. And if they are, you may want to reduce your exposure somewhat, and certainly avoid putting fresh capital into the sector until it becomes apparent that things have bottomed out.
Some sell offs are also caused by a significant negative announcement, or the release of a succession of disappointing information. It could be the result of negative global events – which are generally temporary in nature, and shouldn’t require any action on your part.
Other times it can relate to more lasting troubles, such as a series of negative economic data that point to lower earnings and/or a weaker business environment for the foreseeable future. If that’s the case, you may need to do some serious shifting of your investments to prepare for a longer-term storm.
#3: Will this sell-off matter 10 years from now? – Understanding the long-term implications of the sell-off
Markets can experience mini-crashes. These are short, sharp declines that the market typically recovers from very quickly. Such a crash could be the result of an international event, such as one country invading another. Or it could be caused by negative comments from an influential person, which the market later discounts. In either case, the market bounces back, and the long-term prospects for your investments are not affected.
But as we’ve seen in the past, there are also major sell offs that are neither minor nor temporary. The succession of bank failures during the financial meltdown that began around 2007 was just such an example.
Reacting in a rational way to a major sell off is not at all an easy proposition. Much depends upon how your investments are spread out, and what your time horizon is. For example, if you’re saving for retirement, and your retirement date is in five years, a major sell off can quite literally be a life-changing event.
But if you’re 25 years away from retirement, it will end up being nothing more than a blip in your rearview mirror – at least eventually. That being case, you should continue staying with your long-term investment plan. In all likelihood, nothing more than minor adjustments to your portfolio will be necessary.
#4: Analyze your current portfolio positions
Whether a market sell off is a mini-crash or a longer-term event, it’s always a good time to analyze your current portfolio positions, to be sure that you are properly diversified and prepared for the worst.
Mini-crash or major sell off, you never want to be too heavily invested in stocks in general. Perhaps the worst of all scenarios would be to have 90% of your money in stocks at the very beginning of a major market collapse. For example, even though the market bounced back and went on to achieve new heights after the financial melt down, if your investments were primarily invested in stocks in 2007, the magnitude of the crash might have caused you to panic at or near the bottom of the market.
For that reason, if you suspect any sort of significant decline in stocks is coming, you should seriously consider reallocating your portfolio. Quality often isn’t so important on the way up, but on the way down, quality is everything.
#5: Make sure your positions are fundamentally sound
A good investment will be a good investment, whether the market is rising, falling, or drifting without direction. But the prospect of market sell off is a call to make sure that your positions are fundamentally sound. Most all stocks will get clobbered in a severe market sell off, but companies that are fundamentally sound will bounce back quicker and with more velocity.
How do you determine if a company is fundamentally sound? I look at eight factors:
- Sales Growth
- Operating Margin Growth
- Earnings Growth
- Earnings Momentum
- Earnings Surprises (or more specifically, a history of them)
- Analyst Earnings Revisions
- Cash Flow
- Return on Equity
It’s important to understand that what’s happening in the stock market doesn’t always precisely match the activity in the economy. Even though a company’s stock is falling in sympathy with the general market, the company could still be experiencing growth in both revenues and earnings. These are the stocks that you should favor in your portfolio at all times, but never more so than when facing the prospect of a market sell off.
#6: Make Sure You’re Diversified
In any market sell off certain companies and sectors are going get hit harder than others. But what often happens during the sell off is a change in market leadership. While financial stocks might be the market leaders in the current bull market, the market sell off could change the order, and put technology stocks in the lead.
It’s very difficult to determine which sector will benefit following a sell off. The only way to position yourself in advance is to make sure that you’re adequately diversified among the most likely sector candidates. No matter how much money you have made in certain sectors, recognize that you need to diversify beyond them in order to pre-position yourself for a changing of the guard.
You should also make sure that you have a sufficient low– and no– risk assets, such as certificates of deposit, US Treasury securities, and money market funds. Even though the return on these assets is currently microscopic, they will enable you to preserve capital during the market slide, that will serve you well when it comes to time to buy bargains at the bottom of the stock market cycle.
There’s no need to make a wholesale shift out of equity investments into cash and bonds. You can increase your holdings in safe investments simply by putting new cash into those securities, rather than into stocks. You can also reinvest proceeds into cash and bonds that come from the sale of equity positions that you deem to be particularly risky.
#7: Having Dividend paying stocks will help lower your portfolio’s volatility
So far, we discussed cash and bond type assets as a safe alternative to stocks. But there is a third asset type that represents something of a halfway between stocks and bonds, and that’s dividend paying stocks. These will enable you to collect a regular income on your investments, but you’ll still be in stocks and in a position to capitalize on a market reversal to the upside.
In some respects, dividend paying stocks represent what are probably the best long-term position. This is especially true if they demonstrate consistent attributes of growth stocks as I described in #5 above.
A company that has a long-term pattern of growth, that also returns part of that increased income to its shareholders in the form of dividends, is like money in the bank. Except that it almost always pays a lot more than what the bank will.
With the market being as high as it is right now, you might want to begin implementing several of these steps in anticipation of a sell off. Once again, I’m not predicting that will happen, but we all know that it will sooner or later. Advance preparation is the best reaction to any market sell off. You can do that now while you have the time and the market is calm.