Years of double-digit stock market returns came to an end in 2022 when the U.S. Federal Reserve abruptly ended a decade of lax monetary policy. With inflation hitting a peak of 9.1% by June 2022, the Fed doubled down on a campaign of aggressive interest rate hikes in an attempt to quell it.
As a result, risk assets like equities and cryptocurrencies fell heavily. By Dec. 30, 2022, the benchmark S&P 500 was down 19.4%. The Nasdaq composite index plunged 33.1%, dragged down by its high concentration in mega-cap technology sector stocks like Amazon Inc. (ticker: AMZN), Alphabet Inc. (GOOG, GOOGL) and Meta Platforms Inc. (META).
Bond investors experienced their fair share of losses, too. While bonds have historically reduced volatility and drawdowns when equities faltered, they failed to perform last year. As interest rates rose, bond yields did too, sending bond prices tumbling in a manner not seen since the late 1970s.
Most investors are nursing some losses in their portfolio going into 2023. While meme stock investors on Reddit might chant “buy the dip,” the decision on how to deal with an unrealized loss isn’t always that straightforward. Before deciding what to do with an unrealized loss, investors need to consider both personal and macroeconomic circumstances.
Here are some expert insights and suggestions for how to recover from a loss in the stock market:
— The psychology behind dealing with a loss.
— When to cut your losses and sell.
— When to stay the course or buy more.
The Psychology Behind Dealing With a Loss
If you’re feeling emotional or confused about what to do with your loss, don’t fret — that feeling is normal. The desire to do something, anything, in the moment to assuage those negative emotions can be overpowering, but it is crucial to stay cool, collected and to think things through.
The rationale behind this is rooted in behavioral finance. John Burkhardt, founder and CEO of Capita Neuro Solutions, notes that most investors tend to fall prey to a set of cognitive biases, which can cause them to behave irrationally when facing an unrealized loss.
The first cognitive bias is the endowment effect. “When 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,” Burkhardt says. Therefore, when the price of a stock falls below your cost basis, it can be difficult to part ways with it. Meme stock investors who “diamond hand,” or hold onto, a falling stock with poor fundamentals are an example.
The second cognitive bias is the sunk cost fallacy. A great example of this is the investor who repeatedly doubles down on a falling stock, which is referred to as “catching a falling knife.” Burkhardt says this is because investors tend to become risk-seeking instead of risk-averse when facing a loss. “Investors will grab at any possibility to avoid pain, even if it opens them up to greater losses,” he says.
Investors who fall prey to the endowment effect and sunk cost fallacy will therefore not only cling to losses, but even invest more. The problem with this approach is that the actual fundamentals of the investment do not change. Therefore, the risk of doubling down and riding an investment with poor fundamentals to even steeper losses becomes very real.
When to Cut Your Losses and Sell
The correct approach when handling unrealized losses is to evaluate the fundamentals of the investment in an objective, rational manner. Ask yourself, “Has the thesis behind my reason to invest in this asset markedly changed?” To support this, consider listening to contrarian or opposing arguments and evidence to avoid falling into an echo chamber.
Another great way to take the emotions out of dealing with losses is to set strict, predetermined risk management rules. Anthony Denier, CEO of Webull Financial, recommends implementing this in the form of stop-loss and limit-sell orders for every investment. These are order types that will automatically be executed to sell an investment if it hits a certain price target.
“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. For example, an investor who purchases a stock at a cost basis of $10 might set a stop-loss at $9, and a limit-sell at $12. By doing so, the stock will automatically be sold if it rises by 20% or falls by 10%.
Finally, a sound reason to sell at a loss is to take advantage of tax-loss harvesting. “Harvesting losses on an annual basis is a prudent strategy, as it can aid in reducing any capital gains tax payable or even your taxable income,” says Nilay Gandhi, senior wealth advisor with Vanguard Personal Advisor Services.
When to Stay the Course or Buy More
If your portfolio is diversified and has solid fundamentals, a great way to reframe your state of mind is by envisioning any unrealized losses as a way to snap up great assets at a discount. For example, investors in broad-market exchange-traded funds, or ETFs, can be reassured that by buying the dip, they are effectively investing in a portfolio of hundreds, if not thousands, of stocks that are very likely to recover over time.
While an individual stock might eventually be at risk of bankruptcy, an entire sector rarely is. Comparatively, the market of an entire country overall is more resilient than a single sector. Finally, while the markets of countries can stagnate for long periods, the global market is less likely to do so. By staying diversified as much as possible, investors can set themselves up to invest in the face of losses with greater confidence.
Another great mental exercise is to zoom out and take a long-term perspective. “It’s important to keep in mind that market downturns aren’t rare events, and most will experience at least a few during their lifetime,” Gandhi says. “Bear markets may sting, but many bull market surges over the years have been even more dramatic and often longer, benefiting investors over the long term,” he says. Gandhi’s point is that the length and returns experienced during bear versus bull markets are highly skewed. For example, the typical bear market lasts an average of 236 days with a 28% loss, while bull markets tend to last around 852 days with a 99% return. This underscores the importance of maximizing your time in the market instead of trying to time the market.
Robert Johnson, professor of finance at Creighton University, echoes the importance of time in the market versus timing the market, noting: “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 [annualized] return was cut from 7.47% to 3.35%.”
Because most investors do not have a crystal ball and cannot predict the market’s movements reliably, staying the course and investing consistently through thick and thin is the best way to go. With a diversified portfolio, proper risk management rules and a rational mindset, any investor can become capable of handling themselves — and even thriving — in the face of unrealized losses.
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Update 01/24/23: This story was previously published at an earlier date and has been updated with new information.