The bears are beginning to make their presence felt on Wall Street.
Recently, stocks took a significant hit due to a mix of weak economic data, growing recession fears, and an unexpected rate hike from the Bank of Japan. This hike set off the unwinding of a global “carry trade,” leading to a sharp downturn.
For those wondering where to start with the stock market in such uncertain times, it’s crucial to recognize that what you avoid doing during market downturns can be just as vital as the actions you take. With that in mind, here are three common mistakes you should steer clear of when stocks are in decline.
1. Buying Stocks on Margin
Trading on margin can be risky under any circumstances, but borrowing money becomes especially hazardous when the market is in a downward spiral.
Although it might seem appealing to invest on margin during these times, the increased volatility heightens the risk of encountering a margin call. A margin call occurs when you have to sell off your holdings—or at least a portion of them—to cover your borrowed funds.
Take it from Warren Buffett, who offered this advice in his 2017 Berkshire Hathaway letter to shareholders:
“There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren’t immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
2. Panic Selling
If using margin during a downturn is the cardinal sin, panic selling is a close second. The timing of a market rebound is notoriously difficult to predict, and you don’t want to be sitting on cash when it happens.
Beyond the tax implications of selling during a dip, deciding to sell might feel easy, but figuring out when to get back into the market is the hard part. There’s a psychological hurdle to re-entering, as the market bottom only becomes apparent in hindsight.
So, while selling might have seemed like the right move early this month when the Nasdaq opened 6% lower, it’s important to remember that market drops are temporary. Historically, the U.S. stock market has rebounded from every downturn to reach new all-time highs, and there’s no reason to believe this time will be any different.
There’s no need to panic. You can avoid checking or reading the financial news daily. The market will eventually stabilize, and so will your portfolio if you remain invested.
It’s also worth noting that market corrections are a normal part of the financial landscape. On average, they occur every two years, and bear markets—defined by declines of 20% or more—typically happen every four to five years.
3. Timing the Market
Even if you managed to avoid selling during the initial drop, the temptation to time the market can be strong. However, attempting to do so is far more challenging than it seems.
Short-term market movements are nearly impossible to predict and are often driven by unexpected events. For example, the recent rate hike by the Bank of Japan caught investors by surprise and led to a global sell-off. Additionally, weaker-than-expected economic data, such as the latest unemployment report, contributed to the market’s decline.
What might trigger a market recovery is uncertain. Investors are eagerly awaiting the Federal Reserve’s next meeting in September, where a 50-point rate cut is anticipated.
But market sentiment can change rapidly, and any number of factors could push the market up or down. Instead of attempting to time your market entry perfectly, a more effective strategy is to use dollar-cost averaging or to deploy your cash in stages based on the severity of the sell-off. For example, you might invest 20% during a 10% decline, 30% during a 20% decline, and 40% during a 30% decline.
Once again, Warren Buffett’s wisdom applies here. Regarding market timing, Buffett has said: “Picking bottoms, I think, is probably impossible. When you start getting a lot for your money, you buy it.”
Buffett’s focus on seizing value opportunities as they arise, rather than striving to hit the absolute market bottom, is crucial. This approach is far more likely to yield consistent success than repeatedly attempting to predict the lowest point in the market.
Conclusion
Market sell-offs can be unnerving, but avoiding common pitfalls like buying on margin, panic selling, and trying to time the market can help safeguard your investments. By staying calm and focusing on long-term strategies, you’ll be better positioned to weather the storm and benefit from the eventual market recovery.
