How to Recover After a Loss in the Stock Market
Investors faced strong headwinds to start out the year, with a combination of high inflation, threats of multiple interest rate hikes and geopolitical turmoil creating substantial volatility in the stock and bond markets.
"We are seeing the market undergo a very real correction, especially from the historical highs" hit over the last year, says Jack Zhang, co-founder of social platform Utradea. "It is tough to know if you should be invested in the market right now, and how much risk you should take."
The low interest rate environment of the pandemic-era market pushed many speculative stocks like Zoom Video Communications Inc. (ticker: ZM), Coinbase Global Inc. (COIN), Roku Inc. (ROKU) and Palantir Technologies Inc. (PLTR) to high valuations, but now they're faltering, leaving many investors with mounting stock market losses.
"There are very few market maxims that hold the test of time, but reversion to the mean is one," says Matthew Tuttle, chief investment officer of Tuttle Capital Management. "Whatever stock has a parabolic move up eventually gives up those gains. The stronger the move, the larger the eventual retracement." Indeed, many of the aforementioned high-returning growth stocks are currently down over 50% year to date from all-time highs.
If you happen to be bag-holding some losses, the answer to "What should I do?" isn't always clear-cut or obvious. The decision of whether someone should stay the course, double down, or cut losses is highly contextual, and it depends on the particular asset held, the investor's risk tolerance and the prevailing market conditions at the time.
Here are some tips for how to recover money lost in the stock market, and how to think about different paper losses:
- When to stay invested.
- Buy the dip, or catch a falling knife?
- How to make your portfolio correction-resistant.
When to Stay Invested
"An unrealized loss is just a 'paper' loss, just as an unrealized gain is only a paper gain. Until you sell, the loss isn't set in stone," says Anthony Denier, CEO of trading platform Webull. "If the investor chooses to not sell, continues to hold the asset and lets the loss go unrealized, there's always the possibility that the price will recover to a level where there is no longer a loss and may even create a paper profit," Denier says.
Waiting things out can therefore be a viable strategy, if you still have conviction in your investment and are able to tune out the market noise. While exposure to market risk affects all investments, those with excellent fundamentals should eventually increase in price back to a reasonable valuation. Staying cool, calm and collected here is the key to recognizing this.
"One of the biggest mistakes investors make is letting their emotions drive their decision-making. If the fundamentals are strong, the business model is sound and future growth prospects are solid, then you should probably ignore those thoughts and hold," says Stuart Mooney, co-founder of Utradea. "Knowing what you own – in terms of business model, valuation and projected growth – makes it a lot easier to ignore short-term fluctuations and hold the investment."
For many investors, staying invested in the market might be the most viable solution. The old maxim "time in the market beats timing the market" still rings true today. Panic selling in an effort to time the bottom is exceedingly difficult, with most investors apt to sit on the sidelines too long and miss the recovery. "Looking back over 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 return was cut by more than half," says Robert Johnson, professor of finance at Creighton University. "Fully invested in the S&P 500 for that 20-year time period, the [annualized] return was 7.47%. If you missed the 10 best days, the return was 3.35%. Miss the 20 best days and the return was 0.69%. If you missed the 30 best days, your return was -1.49%," Johnson says.
Buy the Dip, or Catch a Falling Knife?
More risk-tolerant investors with spare cash on the side might be eager to "buy the dip," snapping up previously expensive stocks at a cheaper valuation, or perhaps averaging down the cost basis of an existing position. When the stock (hopefully) makes a rebound, investors can recoup their losses quicker or even reap larger returns.
If you have the stomach to invest during periods of heavy market volatility and have dry powder to deploy, there are a variety of ways to go about it. Statistically, investing in a lump sum produces greater returns, but some investors may choose to hedge their bets by dollar-cost averaging. Other investors may buy into broad-market index funds, which almost certainly go up in the long run and don't pose the same risk of delisting as individual stock picks.
However, there is always the possibility that the dip you buy never stops going down. This is referred to as "catching a falling knife" – when investors sink increasingly large sums of money into a stock pick that never ends up recovering. To avoid being caught in this predicament, investors should understand the fundamentals of their stock well, keep up with company news and have an exit plan.
"Investors should ask themselves why the stock is falling. Is this something specific to the company or a broad market decline?" Denier says. "In a broad market decline, if the company is strong, it may make sense to buy at the lower price. However, if the problem is company-specific, one should take time to evaluate if the company's problems are short term or long term. This will determine whether to sell or buy."
If the fundamentals of the stock have changed and the long-term outlook for the stock no longer appears to be positive, it may be time to cut losses. Cutting your losses can allow you to reinvest the proceeds in a better asset, allowing you to mitigate the opportunity cost. In some circumstances, cutting losses can also be a viable tax-loss-harvesting strategy. Having an exit plan here for what to do under what circumstances is critical for rational, informed investment decisions.
"Before investing, one should determine what their price target is for the stock and sell at least part of the position to take profit when it hits that limit," Denier says. "One also needs to determine how much loss one is willing to experience while waiting for a stock to turn around. If it's a short-term speculative investment, it's best to cut losses while it is still relatively small."
How to Make Your Portfolio Correction-Resistant
"It's best to diversify your portfolio with a mix of asset classes when times are good, to prepare for market downturns," Denier says. "The diversified portfolio should help keep your portfolio in a lower risk profile and minimize large fluctuations by having some assets rise while others fall." Investors who have parts of their portfolio in safer, uncorrelated assets that do well during a correction also reap the benefits of rebalancing.
When it comes to diversifying across asset classes, investors can add small allocations to alternative investments such as gold, commodities or real estate investment trusts (REITs). Historically, these assets have exhibited lower correlations with stocks and bonds, which helps them offset volatility when included in a portfolio. In a rising-rate era in which both stocks and bonds may face strong headwinds, a small allocation to alternatives could hedge against losses and boost returns slightly.
Investors can also diversify across geographies. Examples include buying stocks from international developed markets such as Canada, Japan, Europe and Australia, and from international emerging markets such as China and Brazil. The use of exchange-traded funds, or ETFs, can be useful here for easy, affordable access without the need for extensive research.
Finally, investors can diversify across risk factors, which are sources of returns in the stock market. For example, an investor who holds stocks is exposed to the market risk factor. Because stocks are risky, investors get compensated for that with greater returns. Other risk factors include size and value – generally, value stocks and small-cap stocks are riskier, and thus produce a larger return over long periods of time.
Regardless of what assets you invest in, your behavior and thought process will have the largest effect on how you end up handling losses. "The way to deal with unrealized losses is to understand your risk tolerance for market volatility," Denier says. "Ask yourself if you're still able to sleep at night when the market drops 10% or more." If not, consider critically reevaluating your strategy, he says.
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