What should you do when the market panics? Embrace the opportunity!
The world seems to be coming to an end, markets around the world have had steep drops, and investors are racing for the exits. But if you've got a sound long term investment plan and you've created a well structured portfolio, you shouldn't be panicking at all. No, you should actually be taking advantage of the market panic.
When I worked in the ER, my colleagues called me a pessimist. Rising malpractice premiums, flat reimbursements, increasing workload…there really weren't any good trends in emergency medicine. Similarly, all you're hearing right now in the financial markets is a bunch of bad news: US debt losing it's AAA rating, Europe's debt crisis, high unemployment, slowing economic growth, and so on. There's almost nothing positive in the news right now. While the skies are covered with doom-and-gloom clouds, here are some great reasons to like (dare I say enjoy?) market panics:
Reason #1: Buy cheap stocks
I love Wal-Mart. I actually get a thrill from buying everything from groceries to jeans for some dirt cheap prices. When it comes to investing, however, it seems counterintuitive to buy when others are selling. “Buy low, sell high” seems so easy to say but so emotionally wrong to do. After all there is a cliché in investing which says that the best time to buy stocks is when there is “blood in the streets.”
When perceived risk is high, stock prices go down because investors need to be compensated more for taking on risk. This means that future expected returns are higher. The problem is that no one knows when those returns will happen. But the point is that market panics allow you to buy at lower prices.
Reason #2: Buy more shares
Suppose you bought 20 shares of a stock for $50 per share for a total outlay of $1000. Then, nine months later the share price is $40, a 20% drop (bear market territory). Assuming you still believe in the merits of the investment, you can now purchase 25 shares for the same outlay. This technique, known as dollar cost averaging, assures you that the average price per share is lower than the average of the two prices because you have bought more shares at the lower price. More aggressive investors can use a technique called value averaging, whereby you buy enough shares to obtain a desired dollar amount. In the example above, to end with an investment amount of $2000, you would actually buy 30 shares of stock at $40. These techniques do not assure you of any gain or avoid losses because the stock price can go even lower, but at least it does assure you of reducing your average purchase price.
Reason #3: Reduce your taxes
If my portfolio is tanking, I may as well let Uncle Sam feel some of the pain. If you sell a stock for a loss, you can deduct up to $3,000 of the loss against your ordinary income. If you're in the 35% federal tax bracket, the $3,000 deduction equates to a tax savings of $1,050. Also, if your losses exceed $3,000 you can actually use the excess losses as deductions in future tax years indefinitely. While tax deductions imply stock losses, they also act as cushions to soften the blow.
Reason #4: Dump your losers
Have you gotten emotionally attached to your investments? Market panics should make you question why you bought a particular stock or mutual fund in the first place. Did you buy the stock because you researched the company’s balance sheets, quarterly reports, and financial ratios? Or did you buy the stock because you overheard a surgeon in the doctor’s lounge boasting about how he made a 50% return in just two months? (If this happens, I suggest you ask him why he’s still working 70 hours a week).
Even if you bought a stock or other investment which has positive returns, bear markets are good times to sell those investments if you should not have been purchased them in the first place. One strategy here is to sell these winning investments and avoid a taxable gain by offsetting those gains with losses from other losing investments.
Reason #5: Gauge your risk tolerance
For most investors risk tolerance is directly related to stock prices: in bull markets risk tolerance increases, and in bear markets risk tolerance plummets. One way to determine your willingness to take risk is to evaluate your emotional response to this year’s bear market. There's no better way to know your true risk tolerance than to lose a truckload of money in a short amount of time. Did you sell and invest in cash, or did you load up on Citigroup as it tanked almost 20% today? Another way is to quantify this risk by determining your maximum drawdown, which is the highest percentage loss you are willing to accept before selling an investment. Determining your maximum drawdown over one, three, and five year periods can help you build a more disciplined portfolio and stick with your investment strategy when the next bear market comes out of hibernation.
Reason #6: Appreciate your job
If you've got a job that's pretty stable, savor it. For example, while there are numerous challenges to practicing medicine today, one thing is certain—the demand for physicians and other health care providers and health care affiliates (pharmacists, PAs, nurse anesthetists, etc.) is strong. In effect, your income is similar to a bond in the sense that there is low risk of default (unemployment). If you're a physician, your period of extended “unemployment” occurs right at the beginning of your career (medical school and residency). If you consider your career as a bond, you can actually take a bit more risk with your stock portfolio. While other professions and industries layoff workers, it seems nearly every week my mailbox is flooded with emergency medicine job opportunities across the US. My investment portfolio may be struggling, but my value in terms of human capital is stable. Market panics should make you appreciate the stability of your career.
And finally remember that stock market panics are a normal part of investing. If you don't have a solid investment plan that's addressed potential losses you could suffer in your portfolio, then you need to get one...now! And that's one way I help my clients stay disciplined during market panics.