Beginner’s Guide to Market Volatility

6 smart moves to make when the market drops

“There’s just as much risk in not being invested as there is in being invested."

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When the market hits a rough patch, it’s tempting to react emotionally and to do something to prevent your hard-earned returns from slipping away.

You’ve probably heard advice that doing nothing is often the best course of action, and that can be true. But have no fear: On bad market days, if you feel like you have to do something, there are some smart options.

First, let’s reaffirm that initial piece of advice.

"Do nothing when the market tanks," says Cathy Curtis, a certified financial planner and founder/owner of Curtis Financial Planning in Oakland, California. Decisions made in the heat of the moment are usually regretted, she says. Commit now to doing nothing on bad market days, not making trades out of fear or out of impulse.

Here are six more smart moves you can make:

1. Rethink risk tolerance

As you are doing nothing, pay attention to that sinking feeling in the pit of your stomach. You might learn something valuable for your investing future. After all, if you can’t sleep at night, that’s a problem.

"Afterwards, reassess your risk tolerance and adjust asset allocation if the market action was too upsetting," Curtis says.

But, and this is a big but, it’s important to be aware of the downsides of shifting strategies. Moving to more conservative investments is likely to require reassessing when you could achieve your goals. And nerves shouldn’t take you out of the market altogether.

“There’s just as much risk in not being invested as there is in being invested," she says.

TDAmeritrade crunched the numbers and found that someone who invested in the S&P 500 index from 2001 to 2020 (5,036 trading days) would have earned a 7.4% annualized return, growing a $10,000 investment to $43,730. But those who sold along the way and sat out big upside days lost out: When the 10 best-performing days in that period were missed, the annualized return shrank to 3.3%. And if an investor missed the 20 days with the largest gains, the returns were cut down to just 0.7%.

2. Run toward fear

While you might think of selling after a big drop, you ought to consider doing the opposite.

There's a saying on Wall Street that stocks are on sale after a market dip. Even good stocks are dragged down by the macro mood. So if there is a fund or a stock that you believe in, rough markets create a buying opportunity.

Of course, no one knows if one day's drop was just a blip or the start of a longer rough patch. So if you are unsure that today is a good day to buy, use dollar cost averaging instead. This is where you split the purchase up over many smaller installments with the goal to not buy on a bump and overpay..

3. Don't look!

Long-term trends matter in the market. Short-term gyrations often do not. When things are rocky, you might have an urge to check in on your portfolio, every day, every hour, every minute. Don’t do it. The minute-by-minute updates will slip right past your thinking brain, prodding you to make an emotional (bad) decision. Experts say the ideal strategy is to check in on your portfolio once per quarter.

4. Rebalance

When the dust clears, look at your portfolio and see if the market movements have shaken up your investment strategy. Maybe you had a mix of 60-40 stocks to bonds before, and now you are 55-45. You’ll need to review your asset mix and get back on plan by rebalancing your portfolio.

This can feel strange. It often means you’ll be selling good performers while buying worse performers. But if you believe in your long-term strategy, that’s broadly what you’ll need to do. There are rules and limitations around tax-loss harvesting, so be sure to do your research and consult with a professional before deciding if it fits your strategy.

5. Consider tax-loss harvesting

At some point, you’ll have to pay taxes on gains you earn in the stock market. If you plan to sell anything that year and realize gains, a bad market day can provide a nice opportunity to reduce your tax bill. If you have investments you plan to shed anyway, sell them on down days to realize the loss. Then at tax time, those losses can be used to balance out your investment gains and lower the bill you’ll have to pay to Uncle Sam.

6. Focus on percentages

When the Dow has a bad day, you're likely to hear a dramatic-sounding number like "fell 1,175 points." To your ears, it probably sounds a lot worse than "fell by 508 points." But context matters. In 1987, on Black Friday, a 508-point drop equaled 22.6%. Truly a disastrous day for investors. On the other hand, the February 2018 drop of 1,175, the largest pre-pandemic point drop, was less than 5%. Not fun, but ultimately a blip.

So on bad days, think percentages, not points, to keep things in context.