You wouldn’t be human if you didn’t fear loss.
Nobel Prize-winning psychologist Daniel Kahneman demonstrated this with his loss-aversion theory, showing that people feel the pain of losing money more than they enjoy gains. As such, an investor’s instinct is to flee the market when it starts to plummet, just as greed prompts us to jump back in when markets are skyrocketing.
Both can have negative impacts. But smart investing can overcome the power of emotion by focusing on relevant research, solid data and proven strategies.
Here are three principles that can help fight the urge to make emotional decisions in times of market turmoil.
Crashes happen. Deal with It
Nobody knows when the next market crash will come. Obviously, some prediction of the market’s downfall is going to turn out to be right. The market will go into a major slump again at some point where share prices will fall 20% or more. But it’s impossible to know in advance whether heightened volatility or even a decline that appears to gather momentum will turn out to be The Next Big One.
So, while we may believe we know where markets are headed, we don’t. The same goes for market commentators. They can speculate, prognosticate, prevaricate — and sometimes even provide valuable insights into what’s driving the market — but they don’t really know what the financial markets are going to do in the near term.
Which is why I don’t think it makes sense to shift your money around to outguess the markets, whether that means going to cash to avoid a setback – with the intention of getting back in when the market’s ready to rebound – or moving to an investment you think will thrive while the market dives.
Stick to the plan
A plan is only good if you stick with it. The best and most strict diet in the world isn’t going to help you lose weight if you don’t follow it. Most medication is only effective if the patient takes it consistently and doesn’t frequently miss doses. The same principle applies to your investing plan — if you can’t stick with the plan, it won’t be effective.
The worst deviation from an investing plan is to pull your money out of the market when times get rough. While markets go up and down, it is very difficult to buy at the bottom and sell at the top.
The general long-term trend of the market is up, and the less time you spend invested in the market, the lower your returns.
When creating an investment plan for your portfolio, diversification is the most important rule. The basic objective of diversification is to reduce risk. Though everyone would love to earn high returns without taking any risk, in real life one must manage risk and return together. The best way to do this is by following a disciplined asset allocation strategy.
The asset allocation should not ignore market situations. An asset class trading at elevated valuations will have higher risk compared with an asset class trading low. Diverse portfolios reflect the investor’s goals and risk tolerance. They should be reassessed regularly to ensure the portfolio mix remains balanced and aligned with your investment goals, risk tolerance, financial situation and timeline.
A sudden market crash is unnerving, but it’s not a sign of imminent financial collapse and it doesn’t mean that shares are no longer a good long-term investment. Market crashes are not always negative things for investors. In fact, if you have a lot of your money in cash, crashes can present a great opportunity.
Throughout history, the bear market following a crash has rarely ever persisted for more than a year or two at most before another bull market follows it. Meanwhile, bull markets often last for many years. This means that if you can buy a bunch of great companies at a low price following a crash you will likely be in for many years of gains.