What to do when stocks drop

Here are some investing and trading strategies to help navigate down markets.

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Since hitting an all-time high near 3,400 in mid-February, US stocks—as measured by the S&P 500—are down 10%, having followed global markets lower amid fears of coronavirus spreading.

Big market dips, like the one that has recently hit stocks, can trigger emotions of fear and concern—particularly if they occur suddenly and over a very short period of time. However, they are not uncommon. In fact, the US stock market has a proven track record of recovering from market dips over a long enough period of time. Just look at a multiyear chart as evidence.

One key to successfully navigating turbulent markets is understanding what kind of investor you are, having a plan, and sticking to it. If you become nervous about your investments at any time, take a breath and think about formulating a plan to weather market volatility. Once you are confident in your plan, here are a few things to keep in mind when considering buying into a dip in the market.

Big picture

Each major market move is unique, should be evaluated on its own merit, and should be viewed through the lens of your specific objectives and risk constraints. A significant factor that can shape how you approach market dips is your time horizon.

If you are a long-term investor, for instance, you might consider utilizing excess cash to establish new positions in companies you have wanted to buy and previously felt were expensive. With this strategy, it may be prudent to thoroughly analyze changes to the macroeconomic environment, business cycle, and any other fundamental factors before deciding to buy into a dip.

A resource for longer-term investors to help determine if a stock decline might continue is market and economic commentary. This can help you assess if the risks pressuring the market have the power to push stocks even lower, or if the underlying fundamentals are strong enough to support stock prices. Fidelity's latest business cycle update suggests the US economy is firmly in the late stage of the business cycle, but remains supported by consumption—which accounts for 70% of the economy.

A long-term investor might also choose not to reflexively react but instead to simply wait out market downturns—even the biggest and scariest of them. Case in point: In March 2009, the S&P 500 plummeted below 700, from the then all-time high above 1,500, and is now trading above 3,000. If you went into hibernation in the summer of 2007, stayed invested, and just woke up, it may seem as though markets have steadfastly marched higher without interruption.

Short-term investing outlook on market dips

Some investors have shorter investing horizons. To the short-term trader, pullbacks can present an opportunity of a different sort. Even some buy-and-hold investors who tactically trade with a fraction of their portfolio might try to capitalize on market swings. Of course, this approach comes with more risk, given that it integrally involves market timing—which can be difficult.

If you plan on a short-term buy strategy when there is a market dip, you might also consider a variety of technical analysis tools, such as relative strength, momentum, RSI, and stochastics, to help determine when the market is oversold or overbought on a short-term basis.

With any of these short-term strategies, it may be necessary to implement stricter risk management controls, given that the investing window is shorter and the room for error can be smaller. Specifically, if you are buying a market decline with the anticipation that it will go higher, you should plan for the possibility that the dip isn’t over. Successful planning may involve knowing how you will exit a trade quickly to help preserve part of your initial investment.

One of the most common ways is through the use of a stop order or a trailing stop order. This strategy can be particularly helpful during market dips—where you aren’t sure where the bottom may be. Of course, stop orders are not price guarantees, and may provide limited protection during market declines.

For more flexibility, consider a conditional order, which can be used to trigger an exit from the position you are in based on any number of external factors. Fidelity offers tools like Trade Armor® to assist in taking emotion out of the equation through the use of orders to manage the potential profit and loss targets on a trade. Advanced, knowledgeable traders who are willing to accept the risks involved may even consider using options to hedge their positions.

Another alternative is to simply wait out a market dip. When markets become less volatile, you might resume implementing your short-term strategy.

Make a plan

Time horizon isn’t the only factor to consider. When you are building and updating your investing plan, you may want to account for how you will respond to sharp price moves based on your portfolio’s overall objectives, tax constraints, liquidity needs, and risk tolerance as well.

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