The S&P 500 index recorded its worst first-half performance in more than half a century this year. Through July 1, the S&P is down 19.7% year to date and firmly in bear market territory.
Most stock market sectors face strong headwinds, from high inflation and rising interest rates, including the Federal Reserve’s 75-basis-point increase in the fed funds rate on June 15. Even bonds took a tumble, with the 10-year Treasury yield rising above 3%, sending bond prices plummeting along with equities.
Pandemic-era growth stocks like Zoom Communications Inc. (ticker: ZM), Coinbase Global Inc. (COIN) and Roku Inc. (ROKU), which previously soared to high valuations, are now experiencing deep drawdowns amid a reversion to the mean. Losses in leading technology stocks such as Meta Platforms Inc. (META) and Netflix Inc. (NFLX) following poor earnings reports dragged the index down further.
Needless to say, most stock investors are in the red right now. Save for those with a heavy allocation to energy sector stocks or commodities, most portfolios are likely experiencing unrealized paper losses. While some investors might advocate “buying the dip,” the decision about what to do when faced with an unrealized loss isn’t always clear-cut.
Here are some expert tips and advice for how to recoup from a market correction:
— When to stay invested.
— When to sell at a loss.
— How to manage risk better.
When to Stay Invested
“Investors with a long time horizon and investment objectives should generally consider staying the course,” says Tom Siomades, chief investment officer at AE Wealth Management. These investors can afford a few bear markets and even use them to accumulate more shares as a way to lower their average cost basis.
Siomades recommends dollar-cost averaging, or the practice of deploying capital in scheduled, fixed amounts over time. This prevents investors from lump-summing an amount right before a big correction, which can be psychologically distressing and induce panic selling if investors can’t stomach the loss.
Anessa Custovic, chief investment officer at Cardinal Retirement Planning, agrees: “If you sell your losers when the market is down, you will find it extremely hard to make up those losses. The biggest gains come shortly after corrections or big losses in the market, and it’s extremely difficult to time these big gains, so it’s safest to stay invested rather than miss out.” Timing the bottom can be difficult, and rallies are unpredictable, so staying invested is generally a safe middle ground.
Robert Johnson, professor of finance at Creighton University, notes that “in the 20-year period from Jan. 2, 2001, to Dec. 31, 2020, if you missed the top 10 best days in the stock market, your overall return was cut by more than half.” According to Johnson, investors who sold out and missed these 10 best days had their annualized returns cut from 7.47% to just 3.35%, illustrating the importance of staying invested so as to not miss any future recovery.
Custovic also echoes the advice of Warren Buffett to buy the shares of great companies and hold them forever. She recommends large-cap, blue-chip stocks that have strong cash flows, solid balance sheets and good dividends. During a market crash, these stocks might trade at more attractive valuations despite their strong fundamentals. “This might be the cheapest they will be in a very long time. Getting them at this low price and waiting for the recovery will help recover losses and likely result in gains in the long run,” she says.
When to Sell at a Loss
Staying invested does have a caveat though — the fundamentals of the stocks picked must remain solid and have good potential for recovery and future growth. This isn’t always the case, with history full of previously solid stocks falling from grace and never recovering to previous highs.
Anthony Denier, CEO of Webull Financial, recommends that investors first assess the stock is falling. “Ask yourself: Is this something specific to the company, or is it a broad market decline?” he says. All stocks have market risk, which is the degree that fluctuations in the overall stock market will affect the price of an individual stock. Investors should focus instead on the company’s fundamentals.
Good reasons to cut loose a losing stock include negative changes in a company’s future prospects, such as for growth, competition, management or cash flow. Warning signs may include negative cash flows, lowered management guidance for revenues and earnings, or a dividend cut. Some of these factors may be more qualitative in nature, such as changes in the industry’s competitive landscape, disruption from innovation or shifting consumer preferences.
Denier recommends having an exit plan for every stock in a portfolio. This is commonly a price target at which investors will lock in gains or losses. Setting rules like this may help investors contain the emotions that come with investing and make more rational decisions. “Before investing, one should determine what their price target is for the stock and sell at least part of the position to take profit or cut losses when it hits that limit,” Denier says.
Investors can also sell stocks as a tax-loss harvesting opportunity. Selling a stock and purchasing a different, albeit similarly correlated, stock can avoid running afoul of the IRS’ 30-day wash sale rule. For example, an investor could sell the Vanguard S&P 500 ETF (VOO) and buy the Vanguard Total Stock Market Index ETF (VTI) as a replacement, thus staying invested and harvesting a good tax offset. This way, investors can lock in a short- or long-term capital loss to reduce their short- or long-term capital gains tax later.
How to Manage Risk Better
“Managing risk is about minimizing volatility and drawdowns,” says John Lau, president & CEO at LFS Wealth Advisors. Volatility refers to the degree that investment values fluctuate around their average, while drawdowns refer to the degree of peak-to-trough losses experienced in portfolios. Limiting both helps portfolios stay more consistent and resilient during a crash.
Lau recommends making tactical adjustments and rotating among different asset classes and sectors, noting that “not all asset classes or sectors lose the same in a down market.” For example, he says, commodities and related assets are outperforming in this inflationary environment.
To implement this, Lau suggests allocating portfolios across different assets based on their contributions to overall risk, and rebalancing frequently to sell the winners and buy the losers. This distributes a portfolio’s risk over a variety of assets to limit the chances of any single one overly influencing returns. Generally, this involves buying a diversified mix of stocks, bonds and alternative investments.
Milind Mehere, CEO of Yieldstreet, further highlights the need for diversification, pointing out a common mistake made by index investors who incorrectly believe they’re diversified by buying a common S&P 500 index fund. “The SPDR S&P 500 ETF Trust (also known as SPY), which tracks the S&P 500 index, is a perfect example of a popular fund that allows for broad market exposure but offers limited true diversification,” he says. “Today, the S&P 500 is heavily weighted toward large-cap, growth-based companies with technology as the leading sector.”
Mehere recommends expanding one’s equity allocation to global stocks, including those from developed or emerging markets with lower valuations. He also suggests adding different assets with varying degrees of correlation to equities as portfolio diversifiers beyond just bonds. Alternative such as commodities, real estate, precious metals and managed futures offer uncorrelated or negative correlated performance to stocks and bonds, which can help limit losses during bear markets. “A properly diversified portfolio can reduce volatility without sacrificing returns,” he says.
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Update 07/05/22: This story was published at an earlier date and has been updated with new information.