Stock Market Sell-Off: 3 Mistakes You Need to Avoid
Bears are starting to roar on Wall Street.
Over three trading sessions, from Aug. 1 through Aug. 5, stocks plunged on a combination of weak economic data, fears of a recession, and a surprise rate hike from the Bank of Japan, which triggered the unwinding of a global "carry trade." In just three sessions, the S&P 500 (SNPINDEX: ^GSPC) lost 6%, and the Nasdaq Composite (NASDAQINDEX: ^IXIC) was down 8%.
For investors shaken up by this volatility, it's important to remember that what you don't do during market pullbacks can be just as important as what you do. On that note, here are three common mistakes to avoid when stocks are falling.
1. Buying stocks on margin
It's dangerous to trade on margin in any kind of market environment, but borrowing money from your brokerage is especially risky when stocks are suddenly falling.
As tempting as might be to invest on margin, heightened volatility increases your chances of facing a dreaded margin call, when the brokerage forces you to liquidate your holdings, or at least some of them.
Facing a margin call during a sell-off can be disastrous because you'll have to sell your holdings with stocks down. You'll owe money to your brokerage and potentially lose out on the chance to capitalize on the sell-off.
You don't have to take my word for it. Here's Warren Buffett's advice on trading on margin from his 2017 Berkshire Hathaway letter to shareholders:
There is simply no telling how far stocks can fall in a short period. Even if your borrowings are small and your positions aren't immediately threatened by the plunging market, your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.
Even in good times, trading on margin is too big of a risk for investors like Buffett.
2. Panic selling
If borrowing money to invest during a correction is the cardinal sin, panic selling might be a close second. The timing of any market rebound is hard to predict, and you don't want to be holding cash when it happens.
Ignoring the tax implications that come with selling your stocks during a pullback, selling is the easy decision. Deciding when to reenter the market is the hard part, and there's a psychological barrier to getting back in. After all, the market bottom doesn't become clear until looking at it in hindsight.
So, while selling may have been tempting on Monday morning when the Nasdaq opened down 6%, the free fall won't last forever. The U.S. stock market has bounced back from every sell-off to reclaim new all-time highs, and this one won't be any different.
There's no need to panic. You don't even have to check your brokerage account or read the financial news. The stock market will eventually stabilize and so will your portfolio if you stay in the market.
It's also reassuring to remember that market corrections are normal. In fact, they happen about once every two years, and bear markets (declines of 20% or more) happen every four to five years on average.
3. Timing the market
Even if you didn't sell out of any stocks first, it might be tempting to try timing the market, but that's also much more difficult than it seems.
Short-term movements in the stock market are nearly impossible to predict and often driven by surprise events. For example, the Bank of Japan's recent rate hike took investors off-guard and triggered a global sell-off. Economic data last week, including the unemployment report, was also weaker than expected, further fueling the sell-off.
It's unclear what catalysts might prompt a market recovery. Investors are looking forward to the Fed's next decision in September when a 50-point cut is now expected, and they're hoping for more insight from Fed Chair Jerome Powell at the Jackson Hole conference at the end of the month.
But sentiment changes fast and any number of events could move the market higher or lower. Rather than try to perfectly time your entry in the market, you're better off going with a methodical approach like dollar-cost averaging. You could also deploy some of your cash according to the depth of the sell-off; for instance, 20% in a 10% decline, 30% in a 20% decline, and 40% in a 30% decline.
You can take Warren Buffett's advice once again here. On market timing, Buffett has said: "Picking bottoms, I think, is probably impossible. When you start getting a lot for your money, you buy it."
Buffett's emphasis on taking advantage of value when it arises instead of hoping to find the absolute lowest price is key here. That approach has much higher odds of consistent success than correctly identifying the market bottom again and again.
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Jeremy Bowman has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool has a disclosure policy.
Stock Market Sell-Off: 3 Mistakes You Need to Avoid was originally published by The Motley Fool