The most important factor which determines if you successfully deal with a selloff is how you are positioned before one; avoid emotion and more.
Then faced with a correction or a bear market your portfolio’s risk needs to be properly set to your personality, age, goals, savings and overall position in your life. It’s very tempting when starting a portfolio to take more risk when stocks are moving up and less risk when stocks are moving down.
How to Avoid Emotion in a Selloff
However, if you’re investing for the long term, there will be many of both scenarios. You need to visualize how you’d react when you make 20% in a year or lose 30% in 6 months. When deciding on the amount of risk you’re willing to take, one of the most important aspects is to avoid basing your choice on where you think the market will go up or down in the short term.
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You need to have a baseline plan for all markets to avoid scenarios where you panic. It’s easy to panic when you don’t have a plan in place. If your risk profile is wrong, you will likely underperform. Taking too much risk can cause quick painful losses. If you switch to a more conservative approach after you lost money, it will be difficult to make the money back.
No matter how much you plan or how closely your portfolio matches your risk profile, if you want to go against your plan on a whim of a decision, it’s possible. There can be some circumstances where you need to wait a defined period before you can get your money back, but eventually you will be able to.
You can override your personal financial advisor if you have one and you can take your money out of passive funds at inopportune times if you are making emotionally charged investing decissions. These are all mistakes you can make if you don’t follow through on your discipline. Recognizing you have the freedom to mess up your finances is daunting for some people who aren’t experienced. The key for inexperienced and even experienced investors is to take a methodical approach rather than being reactionary.
Have Plans For Various Scenarios
Having a generic plan if markets move how they usually do is not good enough. It’s very easy to maintain your equity positioning while stocks are going up 8% per year with a moderate amount of volatility along the way. It’s very difficult to maintain a plan when stocks are soaring or crashing.
You’re going to feel the need to act in those circumstances. Instead of acting based on something you decided in the heat of the moment, come up with contingency plans before the volatility comes so that you can act rationally in the face of stress. It’s human instinct to fight or flight which in investing is taking on more risk or less risk. However, it’s best not to overreact.
An example of what you can do when creating a contingency plan is to say, you will increase your US equity exposure by 5% if stocks fall 20% and 10% if stocks fall 40%. In this example, you would be adding new money to U.S. stocks or selling some of other parts of your portfolio in a tax preferable way to get more exposure to US equities.