Investing 101: What should you do when the stock market drops? How to plan for the inevitable now

Investing 101: What should you do when the stock market drops? How to plan for the inevitable now
Invest smarter by making a worst-case scenario plan long before it is time to worry.
Source: solarseven/Shutterstock
Invest smarter by making a worst-case scenario plan long before it is time to worry.
Source: solarseven/Shutterstock

Stock investors — including anyone who invests in a 401(k) — might be feeling exuberant these days. The market keeps on hitting record price levels, most recently on Tuesday, when all three major stock indexes closed at historical highs. At one point in the spring, the stock market went 104 days without falling 1% or more, the longest such streak since the mid 1990s.

Is this cause for celebration? While a rising stock market can certainly lift all boats, a growing body of data-driven evidence suggests equities might be getting overvalued — and therefore due for a fall. And as a result, some investors are starting to get nervous.

“When making money becomes so easy, what usually happens surprises the majority,” Nader Naeimi, head of dynamic markets for Australia’s AMP Capital, said in a phone interview. “Things don’t grow in a straight line.”

On Sept. 3, Naeimi told Bloomberg TV he was holding nearly a third of his fund’s investments in cash in anticipation of a major selloff. After all, high-flying stock prices can be a sign investors are getting greedy and shrugging off risks too easily. Market corrections are an inevitable part of investing: It’s just a matter of “when,” not “if.”

Should regular, non-day-trading folks be worried right now? There’s no easy answer, as even top economists disagree on this point. Complicating matters include a number of exogenous factors, from geopolitical risks like North Korea’s nuclear program to the time of year.

Still, one principle is clear: If you have a financial plan, you’ll be better able to weather any storm, including a correction-driven hit to your retirement accounts. Need some specific guidance? Read on for the basic facts you should know about why investors are worried, plus the concrete steps to take (or avoid) if you want to protect your hard-earned cash.

Why right now is an uncertain time for stocks

The time of year

September is traditionally the worst month of the year for stocks. In fact, it is the only month of the year when the stock market loses value more often than not, S&P Dow Jones Indices analyst Howard Silverblatt said. The market finishes September with higher average prices than when it started only about 48% of the time, Silverblatt said, the worst of any month. October, the next-worst month, sees the market advance about 57% of the time, he added.

“August is always slow, it’s summer months and it’s vacation lazy days,” he said. “September is getting back and seeing all the stuff you have to do.”

So don’t be too surprised if the market dips before October; there’s a good chance that pullback could be temporary... at least in the short-term.

The news cycle

The stock market is influenced by what’s going on in the world on a day-to-day basis in what’s known as the headline effect: Companies with bigger headline effects are more likely to see their prices swing with the news. And there were a lot of big headlines in August, like escalating tensions with North Korea to Hurricane Harvey and the rapidly approaching debt ceiling.

But even wealth managers who are calling for a more cautious approach to investing, like Baird investment strategist William Delwiche, said they didn’t expect such events to weigh too heavily on stocks.

“We remain vulnerable to headline risk, but that’s a day-to-day thing,” Delwiche said. “I don’t see one of these known issues being something that actually forces stocks lower” in the longer term.

Of course, a truly unexpected geopolitical event could change the equation.

The numbers

Even if you’re not sweating the news, there are other warning signs keeping investors up at night. One big concern for some is the fact stock market “valuations,” aka the ratios of how much people are willing to pay for stock compared with its underlying worth, are getting too high relative to history.

One common valuation metric is the price-earnings ratio: When that ratio is high, it suggests people might be paying prices for stocks that are not justified by the fundamentals. Right now, the P/E ratio for the whole S&P 500 is nearly 25; it usually averages close to 15.

Nobel Laureate Robert Shiller recently told Quartz that by his calculations, more people think the stock market is too expensive now than at any time since mid-2000, the peak of the dotcom bubble. In a recent Wall Street Journal interview, John Hussman, a former finance professor who now runs his own fund, called current stock prices “offensive.”

What can you do about a market drop?

Nothing

Sometimes, the wisest reaction to a stock market shock is to do nothing at all, especially if you’re already following a smart long-term rule of thumb for investing — like some form of the birthday rule, in which you base the percentage of stocks and bonds you own on your age. (For example, if you’re 25, you might want roughly 25% of your investments in bonds and the rest in stocks.)

Many investors advocate a “wait and see” approach, at least for younger investors. When Barry Ritholtz, who rose to prominence after a series of smart calls in the buildup to the financial crisis, spoke to Mic in July, he pointed out the stock market always looks wild day-to-day — and that the best course for young investors is to ignore it. “Gee, the stock market looks crazy? Well, you take a whole bunch of monkeys buying and selling, it’s a lot of feces and bananas getting thrown around,” he said. “I’m exaggerating only a little.”

Thus, keeping calm and staying the course is important; that’s what personal finance guru Ron Lieber does, according to his New York Times column. Prominent personal finance writer Carl Richards takes it one step further: When the market makes him anxious, he invests $5. Doing so gives him some semblance sense of control, he said in 2014 — and besides, those little $5 contributions add up.

Strike a better balance

The “do nothing” approach won’t necessarily work for everyone. If doing nothing about market swings makes you anxious, there are still some reasonable actions you can take.

One is rebalancing, which means paring back on asset types that have overperformed — and therefore grown into a larger share of your portfolio — and buying ones that are lagging, with the idea being they’re now a better value and underrepresented in your portfolio.

In the case of a big stock correction, for example, that might mean selling bonds and buying stocks — at least until you hit the goal percentages in your plan, whether through the birthday rule or some other strategy.

While most of the investment advisors Mic consulted for this story recommended a long-term “buy and hold” approach, a few said a correction can also be a good opportunity to change the proportions of your investments a little bit, otherwise known as reallocating.

“I’d likely make some allocation changes to stuff that’s not so expensive,” Naeimi said. “We have great exposure to energy stocks that’ve been totally forgotten and they’re totally cheap.”

This can be a good tactic in good times and bad. If you own lots of overvalued technology stocks right now, for example, Naeimi said, you might sell them and put proceeds toward something more diversified, like a broad index fund.

Seize the day

Is retirement a long way off? A big stock market crash can actually represent a financial opportunity. If you had put just $5,000 into the S&P 500 in March 2009, today you’d be sitting on a portfolio worth more than $18,700. Of course, hindsight is 20/20, and the idea of betting any amount on the market during the nadir of a recession rarely feels easy.

But given their long time horizon, Ritholtz said, a correction could be viewed as boon to young investors: “Millennials should be rooting for a market crash,” Ritholtz said. “We don’t know when the next market crash is going to come from. Millennials should be investing on a regular basis, and then when there’s a market crash, they should take advantage.”

How does that work, exactly? The logic of buying a stock in the wake of a crash is not unlike the logic of buying your winter clothes in the summertime. By buying when no one else does, you might get a discount.

Ritholtz said he was bullish on the long-term market, meaning he thinks it’ll do well when you zoom out and look at multiyear periods, not just days or months. “We have a tendency as investors to miss the big powerful long-arcing forces that are secular in nature and last years and decades,” he said.

Index funds are a cost-effective way to buy into a large number of stocks with a single share. Some people can access these funds through a work-sponsored retirement account like a 401(k), meaning all you have to do to act on Ritholtz’s advice is to simply up your contribution rate, especially if you’re not yet hitting the recommended 20% of your income.

If you don’t have access to a workplace retirement plan, it’s a good idea to open an IRA. Beyond that, you can also buy index funds and individual stocks through a discount — or even free — online brokerage.

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