Buoyed by falling inflation figures and positive earnings reports from leading large-cap tech stocks, the U.S. stock market roared back to life in 2023. Through market close on May 19, the benchmark S&P 500 is up 9.2%, while the tech- and growth-stock-heavy Nasdaq composite has climbed 20.9%.
Still, some investors who endured the bear market of 2022 are likely nursing unrealized losses in their portfolio. In 2022, the S&P 500 and the Nasdaq fell by 19.4% and 33.1%, respectively, on the back of elevated, sticky inflation and aggressive interest rate hikes from the Federal Reserve.
The reason behind this? Mathematically, investment losses and gains have an asymmetric relationship. Bigger gains are required to recover from smaller losses.
For instance, the 19.4% loss in the S&P 500 in 2022 would require a 24.1% gain to break even from. The larger 33.1% loss in the Nasdaq would require a nearly 50% gain to break even from. Markets haven’t rallied quite that much yet, which leaves many investors still in the red.
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While the meme stock crowd on Reddit may advocate for “diamond handing” a loss, referring to the tendency to hold on to a falling investment no matter what, the issue of how to deal with a loss in the stock market isn’t always clear-cut.
When deciding whether or not to cut losses or double down, investors need to carefully analyze numerous factors pertaining to their psychology, portfolio characteristics, risk tolerance, investment objectives, time horizon and tax situation.
Here are some expert insights and suggestions for how to recover from a loss in the stock market:
— When to buy the dip.
— When to cut your losses.
— Behavioral pitfalls to avoid.
When to Buy the Dip
Buying the dip is most advantageous when an investor’s portfolio is already heavily diversified. Ideally, this means a mixture of stocks from different market-cap sizes, sectors and geographies, along with an allocation to bonds, cash or even alternative investments like real estate to further spread out risk.
While some assets may not survive a market downturn, investors who own hundreds, if not thousands, of different assets with varying risk and return characteristics no longer have to worry about this problem. Provided they have the funds and risk tolerance, these investors can proceed to buy the dip with impunity, safe in the knowledge that their portfolio will survive.
Maintaining a long-term perspective is key here. “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,” says Nilay Gandhi, senior wealth advisor with Vanguard. “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.”
An investing adage worth remembering here is: “Time in the market beats timing the market.” Robert Johnson, professor of finance at Creighton University,echoes the importance of this, 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%.”
For those with dry powder ready to deploy, a market downturn can also be a great way of snapping up assets, whether stocks or bonds, at significant discounts. This is especially effective when it comes to broad-market index exchange-traded funds, or ETFs, and mutual funds, which offer much greater diversification than a single stock pick or sector does.
“In market downtowns, it’s important to remain invested and even add additional money to your portfolio if you have extra sitting on the sidelines,” says Lauren Wybar, senior wealth advisor at Vanguard. “Down markets offer a great opportunity to increase contributions while prices are low or set up automatic contributions to buy in at different price points.”
When to Cut Your Losses
What if your portfolio isn’t made up of diversified funds, but rather an assortment of high-conviction stock picks that have since fallen from grace? In that case, blindly buying the dip may not be a sound strategy. For individual stock picks, the possibility of cutting losses comes into play.
When deciding whether or not to cut a loss, investors should try to divorce themselves from personal attachments to a stock. This means evaluating your initial reasons for investing in the stock and asking whether or not a reasonable person would still invest in the stock right now given the current circumstances. The key to success here is to be as rational, detached and mechanical as possible (read: keep your emotions out of it as much as possible).
Evaluate the financial metrics of the company as it currently stands against the prevailing industry, sector and overall economic environment. Listen to contrarian arguments and consider the bear thesis with an open mind. Try not to automatically dismiss opposing opinions as “FUD,” or “fear, uncertainty and doubt.” Remember, it’s important to not fall into an echo chamber.
Another reason to sell an investment at a loss is for tax-loss harvesting purposes. If you have capital gains elsewhere in your portfolio and want to offset them, strategically selling positions at a loss below your cost basis can be an effective way to save money. “Harvesting losses on an annual basis can aid in reducing any capital gains tax payable or even your taxable income,” Gandhi says.
If done right, tax-loss harvesting can even allow investors to stay invested by avoiding the IRS’ 30-day wash-sale rule. “If you want to stay invested, sell at a loss and use the proceeds to buy into a similar, but not ‘substantially identical,’ fund,” Wybar says. “This way you can recoup the loss and participate in upside returns when the market goes back up.”
For example, investors can sell the Vanguard S&P 500 ETF (ticker: VOO) at a loss, while simultaneously purchasing the Vanguard Total Stock Market Index ETF (VTI).
Since VTI and VOO have historically posted almost identical returns and hold a similar portfolio, investors don’t have to worry about missing out on a market rebound after tax-loss selling. And their differing underlying indexes means that neither ETF is defined as “substantially identical” to the other under IRS rules, which can help investors avoid running afoul of the wash-sale rule.
Behavioral Pitfalls to Avoid
However, all of these best practices are for naught if investors cannot steer clear of some common psychological biases and behavioral mistakes. Even armed with the most up-to-date knowledge, investors can still make suboptimal and irrational choices thanks to a unique pattern of cognitive biases that most people fall prey to.
The first cognitive bias to look out for is the endowment effect. The effects of this cognitive bias can often be seen in investors who refuse to part ways with a failing stock, often electing to hold it until an inevitable bankruptcy or exchange delisting.
“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,” says John Burkhardt, founder and CEO of Capita Neuro Solutions, an agency specializing in the business application of neuroscience, behavioral economics and data analytics. Thus, investors may resist the urge to sell even in the face of severe, recognizable consequences.
A related cognitive bias that tends to amplify the endowment effect is the sunk cost fallacy. This can be seen with investors who repeatedly purchase a losing stock in an effort to reduce their cost basis, otherwise known as “catching a falling knife.”
“The sunk cost fallacy occurs because investors tend to become risk seeking instead of risk averse when facing a loss,” Burkhardt says. “Thus, investors will grab at any possibility to avoid pain, even if it opens them up to greater losses.”
By repeatedly doubling down on a poor stock pick, investors are placing their hopes in a recovery, however remote, which is psychologically preferable to the pain of selling and realizing a loss. The culmination of these two cognitive biases is a problem faced by countless investors: clinging to losses and repeatedly buying dip after dip, until either funds run out or the stock hits zero.
By staying cognizant of these behavioral pitfalls, staying diversified and taking advantage of tax-loss selling, investors can better navigate unrealized losses and market downturns. With the right mindset and strategies in place, smart investors can even turn a poor situation into an opportunity to reap larger gains down the line.
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How to Recover After a Loss in the Stock Market originally appeared on usnews.com
Update 05/22/23: This story was published at an earlier date and has been updated with new information.
