The 2022 bear market continues into the fourth quarter. Through Nov. 3, the benchmark S&P 500 is down nearly 22%, with the technology-heavy Nasdaq-100 Index suffering a 34% loss. Numerous mega-cap stocks like Amazon Inc. (ticker: AMZN), Alphabet Inc. (GOOG, GOOGL) and Meta Platforms Inc. (META) plunged after dismal earnings reports, causing investors to withdraw further.
Despite a brief summer rally, hopes for a soft landing for the economy fizzled out as the U.S. Federal Reserve continued its spree of 0.75-percentage-point interest rate increases. Fed Chair Jerome Powell has adopted a hawkish stance, vowing to bring down the highest inflation in decades at all costs.
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Most investors who began investing during the 2020-2021 bull market are likely facing heavy unrealized losses. Aside from investors with the foresight or luck to be on the sidelines in cash or short-term fixed income, most portfolios are likely in the red.
While the meme stock crowd on Reddit might advocate for “diamond handing” their losses — a term describing those who resist the urge to divest from risky assets — the decision to hold or sell isn’t always that obvious. Numerous factors, behavioral and financial, play a role in deciding how investors should respond during a market correction.
Here are some expert tips and advice for how to recover from an unrealized loss:
— How to cope with an unrealized loss.
— When to sell investments at a loss.
— When to stay the course and remain invested.
— How to make your portfolio more resilient.
How to Cope With an Unrealized Loss
Dr. John Burkhardt, founder of Capita Neuro Solutions, notes that investors can often behave irrationally when confronting an unrealized loss. Instead of assessing the fundamentals of an investment and deciding whether or not it remains a good choice, investors often resort to cognitive biases.
“According to prospect theory, losses are felt more strongly than gains,” says Burkhardt. Hence, an unrealized loss of $100 causes investors greater pain than the pleasure of an unrealized $100 gain. The result? Investors with paper losses often fall prey to the “endowment effect.”
“The endowment effect says that once you’ve picked a stock, you feel like you own it, and thus need to receive a greater amount of money to be willing to part with it,” says Burkhardt. Accordingly, investors can find it mentally difficult to sell if their stock has dropped below their purchase price.
Burkhardt also notes that when investors face unrealized losses, they tend to become more risk-seeking. “Most of us have heard that people tend to be risk-averse, but this only applies when we’re looking at gains,” he says. “When people are facing losses, the reverse happens.”
Thus, when investors are staring down a potential loss, they are more willing to take risks. According to Burkhardt, this is because investors will grab at any possibility to avoid pain, even if it opens them up to greater losses. A classic example is the investor who repeatedly “buys the dip” for a failing stock that eventually gets delisted and goes bankrupt, called “catching a falling knife.”
The crux of these behavioral mistakes is the sunk cost fallacy. An investor who falls prey to this fallacy may feel as if they can’t escape and their only solution is to invest more. “The dangerous part is that every time we double down, we make it even more difficult to exit, and the risk of our portfolio increases with every poor successive decision,” says Burkhardt.
[READ: How to Pick Stocks: 7 Things All Beginner Investors Should Know]
When to Sell Investments at a Loss
So, the decision to sell at a loss means being aware of these cognitive biases and assessing the fundamentals of your investment in a rational manner. Good reasons to sell a stock include fundamental changes such as heavy insider sales, revised management guidance for revenue and earnings forecasts, dividend cuts, and notable pending regulatory or legal penalties.
Anthony Denier, CEO of Webull Financial, recommends that investors have a rational and rules-based exit plan in the form of a stop-loss order for every investment. This is the price at which an investor will auto-sell a stock to limit losses. “Before investing, one should determine what their price target is for the stock to sell and take profit or cut losses when it hits that limit,” Denier says.
Finally, investors can also strategically sell stocks at a loss in taxable brokerage accounts for tax-loss harvesting purposes. Selling a stock to lock in a capital loss can help investors offset future capital gains tax. To avoid the IRS’ 30-day wash sale rule, investors must not purchase a “substantially identical security.” For instance, selling Visa Inc. (V) and buying Mastercard Inc. (MA) could be an option, given the two are correlated but are different securities.
When to Stay the Course and Remain Invested
Long-term investors with diversified portfolios should generally consider staying invested and riding out market volatility. The risk of a single stock collapsing and wiping out your portfolio value is significantly less if you hold broad-market index funds. While there may be volatility from market risk, the chances of a well-diversified portfolio never recovering are remote.
Some investors may be tempted to sell to cash and attempt to buy back in at the bottom. This is a form of market timing, and it is difficult for even professional investors to pull off. Bear markets can be drawn-out and prone to numerous false rallies known as “bull traps.” When the recovery does happen, it tends to occur suddenly and over a short period, which can easily be missed.
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 from 7.47% to 3.35%.” Timing these exact 10 days would have been extremely difficult, so the best solution is to stay the course and practice dollar-cost averaging, or the practice of investing money in scheduled, fixed amounts over time.
[SEE: 9 Best Stocks for a Starter Stock Portfolio.]
How to Make Your Portfolio More Resilient
A stock market correction is an opportunity to learn about your true risk tolerance. If the unrealized losses in your portfolio are keeping you up at night, consider dialing back your portfolio’s asset allocation to a more conservative mix. This can help you cope better when the markets take another inevitable downturn in the future.
Most investors manage risk by reducing volatility, or the degree that their portfolio’s value fluctuates up and down. This is usually done by allocating more to bonds. The downside of this approach is that during rising-interest-rate bear markets, bonds can fall almost as much as stocks do.
Conditions like this have occurred in 1931, the late 1970s and early 1980s, and in 2022 so far. Many investors who held traditionally “balanced” portfolios were likely shocked by how much their holdings dropped relative to the stock market.
There are two ways to remedy this. The first and most simple way is to substitute low-risk fixed-income assets, such as certificates of deposit or short-duration bonds, such as Treasury bills, for the usual bond funds. These assets are less sensitive to interest rates and have a very low chance of default.
The other solution is allocating to alternative, hedge-fund-like investments. As Andrew Beer, managing member at Dynamic Beta Investments LLC, notes: “In early 2021, hedge funds overall made a gutsy call: Inflation is back. Unlike most investors, they’ve sidestepped the stock and bond bear market.”
These types of alternative investments have two goals: Produce positive expected returns under all market conditions and achieve a low correlation with stocks and bonds. Thus, when stocks and bonds fall, alternative investments like managed futures can shine.
Case in point, Beer notes that as an asset class, managed futures are up 28% in 2022 while stocks and bonds sold off. “Managed futures funds have hit the trifecta: big gains during the dot-com bust, the 2008 Great Financial Crisis, and this year so far,” he says.
Thus, investors can diversify the traditional portfolio of stocks, bonds and cash to also include an allocation toward alternatives. The combination of positive expected returns and low correlation can help a portfolio reduce volatility without hurting long-term performance.
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How to Recover After a Loss in the Stock Market originally appeared on usnews.com
Update 11/04/22: This story was previously published at an earlier date and has been updated with new information.
