The market can be a rollercoaster, and while the S&P 500 is up 10.4% year to date as of May 29, not every sector or individual stock reflects this upward trend.
For example, the S&P 500 real estate sector is down 8.5% this year, affected by high interest rates, a sustained downturn in commercial property prices and lower occupancy rates. Meanwhile, the consumer discretionary sector is essentially flat, largely due to Tesla Inc. (ticker: TSLA), which has dropped about 29% year to date.
For those who have ventured beyond broad indices and into more speculative investments, the losses could be even more substantial. Take the example of investors who jumped on the meme-stock bandwagon with AMC Entertainment Inc. (AMC) and GameStop Corp. (GME) during the frenzy of February 2021.
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Both meme stocks have plummeted, with annualized losses of 69.1% and 45.8%, respectively, since then. An initial $10,000 investment in either AMC or GME at their peaks would now be worth only $221 and $1,365, respectively, after facing numerous dilutions, disappointing earnings and reverse stock splits.
While some investors advocate holding onto declining stocks no matter what — referred to as “diamond-handling” on forums like WallStreetBets — it’s crucial to consider whether maintaining such investments aligns with your financial goals and risk tolerance.
“Keep in mind that unrealized losses are a natural part of investing, but a sound investment framework emphasizes diversification, so a single stock’s decline shouldn’t derail your entire portfolio,” says Michael Ashley Schulman, partner and chief investment officer at Running Point Capital Advisors. “Re-evaluate the position, but remember the importance of spreading your risks.”
Here are some expert insights on how to recover from a loss in the stock market:
— When to cut a loss.
— When to stay the course.
— How to tax-loss harvest.
When to Cut a Loss
“Unrealized losses sting, but for long-term investors, the decision to hold or sell shouldn’t be driven by short-term emotions,” Schulman says. “Focus on the company’s or industry’s long-term prospects and whether the fundamentals still support your original investment thesis.”
To manage losses effectively, investors need to pinpoint why their stock’s value has dropped and assess whether the reasons could lead to long-lasting negative impacts.
Fundamental red flags that might warrant selling include severe issues such as an accounting scandal, a dividend cut, slashed operating margins or impairments to key company assets. In addition, actions by management that erode shareholder value, like consistent stock dilution, multiple reverse splits or the issuance of toxic convertible debt, may be a valid reason to sell.
“Cutting your losses can feel emotionally difficult, but investors shouldn’t be afraid to hit the eject button if a stock’s fundamentals have weakened,” Schulman says. “Think of your portfolio like an airplane — sometimes you need to shed weight to weather the storm and reach your destination.”
The key is to remain unattached to any single company and avoid treating investing like a team sport. While it might be comforting to find support among like-minded investors via online communities, this can sometimes reinforce a groupthink mentality that perpetuates the sunk cost fallacy.
“The sunk cost fallacy occurs because investors tend to become risk-seeking instead of risk-averse when facing a loss,” says John Burkhardt, founder and CEO of Capita Solutions, an agency specializing in the business application of neuroscience, behavioral economics and data analytics. “Thus, investors will grab at any possibility to avoid pain, even if it opens them up to greater losses.”
This can be seen with investors who repeatedly double-down on a losing stock to “average down,” in the hopes that a possible rally may allow them to finally sell and break even. While this is possible, experts warn it’s not a good idea, and is instead akin to “catching a falling knife.”
“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 explains. This behavioral bias can cause an investor to myopically focus on the stock price instead of assessing its fundamentals honestly.
Schuman agrees with Burkhardt, noting: “We’ve seen people hang on to losing positions for years, holding out hope to eventually be right; this is rarely a winning strategy. To put it another way, you don’t have to eat the whole apple to realize it is rotten.”
[READ: How to Pick Stocks: 5 Things All Beginner Investors Should Know]
When to Stay the Course
On the other hand, suppose you hold high-quality assets like shares of Warren Buffett’s conglomerate Berkshire Hathaway Inc. (BRK.A, BRK.B), which boasts double-digit operating margins, high return on equity, a diversified portfolio of public and private holdings, and sits on a cash pile of over $180 billion.
Despite these quality metrics, an investor holding BRK.B would have seen their investment draw down by 19.3% during the worst part of the March 2020 COVID-19 crash.
Even with the benefit of hindsight, it’s clear that this unrealized loss had nothing to do with a deterioration in BRK.B’s fundamentals — the company was still generating significant cash and had no specific negative catalysts. So, what caused this?
The culprit was market risk, also known as systematic risk — the type of risk that affects the entire market and is inherently unavoidable. This form of risk is tied to factors that impact the broad financial markets, including economic changes, geopolitical events or global financial crises.
Essentially, it’s the volatility that investors must accept when investing in the stock market. Because it cannot be diversified away, it’s a fundamental driver of the expected return on all investments above the risk-free rate.
With a five-year monthly beta of 0.89, an investor could expect BRK.B to move more or less in line with the broader market, and also crash when the market does. But this doesn’t mean that BRK.B suddenly became a bad investment and deserved to be sold for an unrealized loss during COVID.
The takeaway? If you’ve honestly and objectively assessed your holdings and determined they’re high-quality companies, then staying the course during market turmoil amid unrealized losses is a good idea. During this time, you can stay proactive by diligently reinvesting dividends or dollar-cost averaging.
“By continuing to reinvest dividends when the market goes down, you’re buying at lower prices, and therefore buying even more shares of a particular security,” says Lauren Wybar, senior wealth advisor at Vanguard. “Down markets also offer a great opportunity to increase contributions while prices are low or set up automatic contributions to buy in at different price points.”
Alternatively, taking a hands-off approach altogether to alleviate stress by tuning out financial news and avoiding checking your portfolio might be beneficial, especially when the sky appears to be falling.
“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 at 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.”
Finally, if you own a diversified fund tracking indexes like the S&P 500, this decision becomes even easier. With this approach, your long-term investment thesis hinges less on a particular company or sector doing well, and more on the overall U.S. stock market continuing to grow long term. By avoiding panic-selling, you can ensure you capture the full potential of the inevitable rebound.
“Time in the market beats timing the market,” says Robert Johnson, professor of finance at Creighton University’s Heider College of Business. “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%.”
How to Tax-Loss Harvest
There’s another strategic way to potentially lower your future tax liability called tax-loss harvesting. “Tax-loss harvesting can be a silver lining when the markets are turbulent,” Wybar says. “Investors cannot control the inevitable ups and downs of the markets, but they can control when to lock in losses within their portfolio.”
Tax loss-harvesting allows you to either offset capital gains or, if losses exceed gains, deduct up to $3,000 against ordinary income annually. Moreover, if there are any leftover losses, they can be carried forward indefinitely to use at a later date when you have more capital gains to realize.
However, there are nuances to consider: First, short-term and long-term capital losses must be initially applied to short-term and long-term capital gains, respectively. Second, you can’t sell an investment to claim a loss and immediately rebuy it or another “substantially identical” one to stay invested due to the wash sale rule. You must wait 30 days or choose a different asset.
But there are legal ways to circumvent this. “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, if you sell Mastercard Inc. (MA) at a loss, you can immediately buy its competitor Visa Inc. (V) to retain your exposure to the credit card industry duopoly.
This tactic is even more versatile if you’re a fund investor. Many funds have similar risk and return profiles but different underlying benchmarks, making them not substantially identical.
For instance, Vanguard S&P 500 ETF (VOO) and Vanguard Total Stock Market ETF (VTI) have historically returned similar 10-year performance, with 12.4% versus 11.8% annualized, and share similar top holdings.
However, because they track different benchmarks — the S&P 500 and the CRSP U.S. Total Market Index, respectively — an investor could sell VOO below their cost basis, claim the tax loss and immediately deploy the proceeds of the sale into VTI to remain invested.
Keep in mind that tax-loss harvesting only works in a taxable brokerage account. “It is a way to make lemonade out of lemons; however, it does not apply if your losses occur inside a tax-free or tax-deferred account like an IRA, Roth IRA or 401(k),” Schulman explains.
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How to Recover After a Loss in the Stock Market originally appeared on usnews.com
Update 05/30/24: This story was previously published at an earlier date and has been updated with new information.
