Top 4 Mistakes to Avoid When Investing During a Market Decline

  1. Timing the Market
  2. Lack of Diversification
  3. Ignoring Fundamentals
  4. Overreacting to News

Top 4 Mistakes to Avoid When Investing During a Market Decline

Timing the Market

Investors naturally get scared after sudden market drops, and one of the most costly mistakes they make is trying to time the market. Trying to consistently time the market is notoriously challenging—even for the pros.

What impact are they missing out on key dates in the market?

Take the J.P. Morgan study, which found that missing the 10 best days in the market between 1999 and 2018 could turn a 3.13% median annual portfolio return into -0.04%. What if an investor missed the best 20 days?

Let me illustrate it further by giving you an extended scenario:

Since, an investor who held on to the S&P 500 over those 20 years would have grown a $10,000 investment into roughly $32,421. If that investor failed to hit only the 10 best days, their $10,000 would only grow to approximately $16,180. As you can see, missing the 20 best days lowers the $10,000 to a mere $10,167, which is barely in the black after twenty years.

This data point reinforces the importance of staying the course in your investment journey and not trying to time the short-term market.

Examples in History and Professional Opinion

As legendary investor Warren Buffett said, “The stock market is designed to transfer money from the Active to the Patient.” This serves as an example of why not to get in and out when the market is low. So those are the three things that come to mind: management, making sure you treat the money as your own, and of course, timing—he says not to time the market so you have to be patient with it and be sure to keep doing this if you are in the investing game.

Bestselling Behaviour

During the 2008 financial crisis, many investors dumped their stocks in a frantic climb that turned out to be a bluff, with many missing out on substantial gains during the recovery period. Investors who stayed with a diversified approach of corrected and re-balanced portfolios generally recovered much of their value and in many cases have seen large gains in the years that followed. Over only the period of March 2009 thru the end of 2010, the S&P 500 rose >68%.

Ramit Sethi, author of “I Will Teach You to Be Rich,” gives the low-down: “When it goes on sale, it is a sale: It is shocking how many sophisticated people do not understand this…you’re happy about it!” You would probably buy your favorite product on sale if you could get it for a cheaper price. None of the rules in investing stocks is different. The common sense upon which this is predicated is that if you see a stock that you think is a great long-term investment, you should be investing in it regularly. Anytime the price goes down, just take it as a chance to buy more for your buck.

Lack of Diversification

Lack of Diversification: One of the key errors investors make when the market goes in reverse is keeping their portfolios oversized in just a few positions. Without it, your portfolio can get hit hard should one single asset or sector perform poorly.

Results of Not Diversifying Widely In comparison, the S&P 500 index cratered approximately 38.5% during the 2008 financial crisis. Those investors heavily weighted in financials saw their portfolios obliterated, as some of these stocks dropped over 80% in value. Meanwhile, those who had tentacled out to bonds, or international stocks, held steadier losses, and showed signs of quicker recovery.

Here is a more detailed example of it: In 2008, for example, an investor holding a concentrated portfolio of U.S. financial stocks would have suffered huge losses. For example, a diversified investor owning assets across bonds, international stocks, and commodities would have experienced smaller declines and faster stabilization.

History and Scholarly Commentary One of the best examples of the benefits of diversification was the “Lost Decade” of the 2000s. For inflation years 3 onwards, the real return on the S&P 500 was annualized at 0%, investors in this index spent a decade in neutral.

Here’s John C. Bogle, the founder of Vanguard Group, explaining the importance of diversification: “Don’t look for the needle in the haystack. Just buy the haystack!”

Effective Diversification: Planning Techniques

Diversify Across Asset Classes: Invest in a mix of stocks, bonds, real estate, and commodities to spread your portfolio. This reduces the risks that come from any one class underperforming. For example, 60% for stocks, 30% for bonds, 10% for real estate and commodities. Even if the stock market crashes, bonds and real estate can help with stability and income.

Geographical Diversification — Invest in different regions and markets in the world. Although the U.S. markets do not always excel, enabling access to international markets affords investors more growth possibilities as well as risk diversification. For example, put 50% in the U.S., 25% in developed international markets, and 25% in emerging markets.

Sector Allocation: Avoid concentrating too much in any individual sector. Diversify your investments in different areas like tech, health care, commerce, and consumer brands. For example, if you had a tech-heavy portfolio during the dot-com bubble burst and lost a bunch of money in your 401k, you might have been better off by not opting in. People who had investments in other areas of the market like health care, consumer staples did a bit better.

Index Funds and ETFs: Index funds and ETFs are diversifying by their nature since they own many assets across different stocks in a single (or few) fund. Example: One fund might track the performance of 500 large U.S. companies (the S&P 500 index) and another might provide exposure to thousands of companies around the world by using a fund that tracks a global stock index.

Rebalancing Your Portfolio Rebalancing means selling assets that have done well and buying those that have done less well, so that you return to your target allocation.

Annual Rebalancingregular schedule to review and adjust your portfolio at least once a year. This systematic approach will help in keeping you disciplined from deviating away from your investment objective.

Threshold Rebalancing — If an asset class goes X% beyond your target allocation then rebalance. At 60% stocks, 40% bonds, with 65% stocks or 55% stocks, rebalance.

To minimize investment risks: Diversification and the long run

Bridgewater Associates founder Ray Dalio has espoused what he calls the “Holy Grail of Investing” — allocating to at least 15 uncorrelated assets. In fact, Dalio says this approach can cut risk enormously, without meaningfully giving up average gains. He adds, “The biggest mistake that most people make is that they don’t look at themselves and the things they own globally.”

Ignoring Fundamentals

Investors make one of the biggest mistakes during a market downturn when they fib the fundamentals of the companies they are investing in, and the only way forward is to fall back on them for informed decisions and do not panic sell. There is a higher chance for companies with strong financial health, great business models, and strong management to go through the economic tidal waves and come out stronger.

Role in Fundamental Analysis

A basic approach used in stock trading, where investors consider some quantitative and qualitative measures while analyzing company financial statements, company management, competitive advantages, and market conditions to estimate the value of the stocks is fundamental analysis. That way, investors will know which stocks are being undervalued—or overvalued—by the market.

For instance, during the early 2000s, many tech stocks collapsed because of speculative overvaluation in the dot-com bubble burst. But companies like Apple and Amazon, which came in a [crashing] wave of a 90% dive in their stock followed by 98% the year after, not only lived through it but grew into multi-trillion-dollar companies. Long-term investors who looked through short-term market gyrations to the strengths of the companies themselves did quite well.

What Makes up Fundamental Analysis

Financial Statements — Look at the company’s balance sheet, income statement, and cash flow statement to evaluate a company’s financial health. Look for:

  • Revenue Growth: Strong businesses grow revenue over time
  • Profit Margins: On profit margins, higher and stable margins is a parameter to look for; they show the management is efficient.
  • Debt Levels: Low debt-to-equity levels reduce financial risk.
  • Quality of Management: Assess the history and credibility of the company leadership. Good management will help guide you through rough waters and take advantage of opportunities.
  • Unique Selling Propositions, Patents, Brand Strength, or Cost Advantages: What makes the company better than the competition? They call this a “moat” as Warren Buffett would say.
  • Market Share: In terms of market position, get detailed insight on the market share of the company and its placement in comparison to the biggest fishes in the market. Market Leading Position: Covanta holds a leading position in a stable market, which should allow it to command a slight pricing power.

Ignoring the Basics: Historical Examples

For example, in the financial crisis, why did investors sell just about everything en masse, without regard for the health of the individual companies in question? Some, such as Johnson & Johnson and Procter & Gamble, which had solid balance sheets, were able to keep earning money and pay dividends.

It reminds me of a quote from Peter Lynch, the legendary mutual fund manager, that you actually should know what the companies you invest in do: “Know what you own, and know why you own it.”

Overreacting to News

Investors overreacting to news during a market downturn is one of the most destructive mistakes that they can make. Staying in the game (long-term) and continuing to execute on your investment plan rather than reacting to market gyrations every day is crucial.

The Downside to News Overreaction

In downturns, there is usually an avalanche of negative news aimed at getting an emotional response from investors. It’s called “herd behavior” when individual actions become correlated with the larger group moving quickly back and forth over the same “fence,” so to speak.

As an example, during the 2020 lockdown and the virus outbreak, the S&P 500 dropped by more than 30% in a few weeks. During this market downturn, many investors were driven by fear and uncertainty, selling at the bottom. Yet those who stuck with it saw their investments whipsawed by an incredible bounce-back: following the 2020 bear market nadir, the S&P 500 recouped ~70% between March and the close of 2020.

Examples of Overreaction Throughout History

The Crash of ’87: Dubbed “Black Monday,” the Dow Jones Industrial Average fell by 22.6% in a single day thanks to tip utilizing and financial specialist fear on October 19, 1987. But the market rebounded rapidly, and by the end of the year, most of the losses had been recouped.

Brexit Vote (2016): When Brits voted to exit the European Union, global markets plunged. Less than two hours after the vote, the FTSE 100 index plummeted more than 3 percent. But the market recovered within weeks, and the FTSE 100 closed higher at the year-end than it started.

John Templeton, a pioneer in global investing, and a wise man with an even wiser beard, used to say the following: “The four most dangerous words in investing are ‘this time is different.’” This quote reminds us that short-term news should not be overreacted to as market corrections and recoveries are part of the economic cycle.

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