The Stock Market Declined…Now What?

The stock market declined…now what?

What do you do? 

Are you supposed to do anything?

I was talking to my fiancée yesterday because she looked at her retirement accounts for the first time in a few months. She has really absorbed the lesson not to look at her investment accounts that often because markets being up in a single day is only a little better than a coin flip, but if you look annually, markets are positive about 70% of the time. 

She noticed her accounts were down about 10% this year and reminded herself that the market rewards long-term investors, but she was still disappointed to see it down. 

When the stock market is down and your investment accounts are also down, it can feel terrible. If the stock market is down 10%, perhaps you watched the money you worked hard for go from $10,000 to $9,000. 

With the global stock market down about 13% year-to-date (as of May 1), it can feel like you should be doing something. 

Should you? And if so, what? 

Let’s explore what you can do during stock market declines. 

Review Your Investment Policy Statement

The first step you should take is to review your investment policy statement (IPS). Oh, you don’t have one? 

It’s time to write it!

Your IPS is the framework for how you are going to invest. It sets the rules in advance, so when markets decline, you have already written yourself a prescription for what you are going to do. 

You could even write in the IPS that when the stock market declines 10%, you will do nothing. Another alternative is that when the stock market declines 10%, that may be an opportunity to rebalance. Rebalancing is when you sell what has done well and buy assets that have done less well to get back to the target mix.

The IPS will say how much of your portfolio will be in stocks, bonds, and other alternative asset classes. It will say the target of each, such as 90% stocks, 5% bonds, and 5% alternatives, as an example. It will say exactly when you will rebalance, which could be time-based, such as once a year. You could also choose to rebalance based on bands, such as when your stocks are more than five percentage points away from the target. In the targets above, that would be 85% stocks or 95% stocks. 

Your IPS acts as a map for your investing experience. Why would you invest your life’s savings without first creating a map or rulebook? 

People tend to make significant mistakes when the stock market declines. Our emotions tend to get the best of us, which is why creating an IPS in advance when you are level-headed can be helpful for when the stock market is down, and it feels like the world is in a truly awful place. 

You can consult your IPS now, or if you don’t have one, you can create it now. If you create it now, I also suggest revisiting it when the stock market isn’t down as much to see if your feelings and what you wrote are similar. 

Buy The Dip

You could invest more with the stock market being down.

Buying the dip isn’t a good investment strategy. It’s been proven that long-term, buying the dip as a strategy of when to invest money underperforms buying on a regular basis (dollar-cost average). 

You might be wondering then, why mention this as an option when the stock market is down? 

I don’t suggest leaving money in cash waiting for a dip, but if you have extra money in cash or can save a little extra, it can feel good behaviorally when the stock market is down.

It’s the same way you get excited when you want to purchase something at the store for 10% off. 

When you buy it, or in the case of investing, when you invest it, it can feel like a little win. Those little wins can be critical when stock markets are down. They can give you enough energy to stay on track with your investment policy statement. 

Please keep in mind that stock markets don’t always go down and recover. You may buy at 10% only to see the stock market drop again, buy at 20% down, and so on. This can happen multiple times before the stock market recovers. It can make buying the dip frustrating because you are investing money at multiple points in time only to watch that new money drop again. 

However, at some point, at least historically, the stock market recovered and you would have felt good that you invested money while it was down. 

Again, I’m not advocating for buying the dip as a long-term investment strategy. You’ll likely be in cash too long and miss out on performance. If you do have extra cash for whatever reason or want to invest an extra $100 or another amount meaningful to you to buy extra at lower prices, it can feel like a small win and something you can control in a time where you can’t control much. 

Remember the Time Frame for Using the Funds

You may already have this in your investment policy statement, but I want to call it out as a separate action to take because it’s where I see people frequently make mistakes. 

If you see your retirement money go down and you are in your 20s and 30s, there are very good odds you are not using this money for at least 20+ years. 

What does it matter if the stock market is lower today?

You should only care what the value will be when you plan to use it. In fact, with the stock market lower today and still saving, you get to invest regular contributions into a lower market. Long-term, that should benefit you. 

Now, if you are trying to buy a house in a year and invested money for that purpose, that’s problematic. You want to align your investments with when you want to use the funds. Since stock markets can fluctuate 50%+ in a year, you don’t want to invest money for short-term needs, such as buying a house in the next year, into the stock market. If you need $100,000 for a down payment, but you invest it and it goes down 50%, you now have $50,000 for a down payment. Now, you can’t buy the home you were hoping to get. 

For those with long time horizons, such as retirement in multiple decades, the stock market declines today are unlikely to have much of a long-term impact on you. If stocks go down 30% this year, but you have 30 years of other stock market returns, it is likely going to wash out the severity of any experiences this year and approach the long-term average.

For example, if stocks are down 30% this year and then up 20% the following year, you would be down 16% overall. Since there are only two years of investing, the 30% negative year has a significant influence on the result. 

If you invested for 10 years and got the following results:

1. -30%
2. 20% 
3. 5%
4. 12%
5. -10%
6. -1%
7. 9%
8. 24%
9. 14%
10. 3%

Here is what you would have experienced:

What you will notice is that three out of the ten years are negative, which is close to historical averages. I made up the annual return numbers, but they work out to approximately a 40% cumulative return or a 3.40% annual rate of return. 

I highlight these returns because even by the end of year 7, you likely are not feeling good because your portfolio value, $96, is still below what you originally invested, $100. 

You needed to be patient and disciplined to work towards the longer-term average. If you had given up in year 6 or 7 after the negative returns, you would have missed the strong positive returns that followed. 

This is why it’s important to remember when you plan to use the funds. Imagine an investor experiencing the returns above, but not needing to use them for 30 years. What does it matter that the stock market went down 30% in year 1? 

It’s a drop in the hat compared to the next 30 years of stock market returns. 

Over time, that negative 30% will likely wash out and hardly be something remembered 30 years from now. 

Rebalance and Tax-Loss Harvest in Brokerage Accounts

If the stock market drops enough, there may be positions in your portfolio you need to rebalance.

For example, if you are targeting 30% in developed international stocks and it now makes up 20% of the portfolio, maybe your investment policy statement says to rebalance. In that case, you may decide to sell other parts of the portfolio that are above target to buy parts of the portfolio that are under target. 

Although this can seem counterintuitive (sell the assets doing well to buy the assets doing poorly), this is how “buy low, sell high” works. 

You sell the parts of the portfolio that have done well to buy more of the parts of the portfolio that have struggled recently. Historically, that has rewarded diversified long-term investors. 

In addition to rebalancing the portfolio, if you have assets with losses in a brokerage account, you may want to tax-loss harvest.

What I mean by that is you can sell an asset at a loss to help reduce your taxes. For instance, if you buy an ETF for $10,000 and it went down to $9,000, you could sell it, and book a $1,000 loss for tax purposes. That loss can be used to offset current-year capital gains or if you don’t have any capital gains, offset $1,000 of ordinary income.

If you had enough losses, you could offset up to $3,000 of ordinary income, and then future capital losses carry forward to be used to offset future capital gains or up to $3,000 of ordinary income annually. 

Now, you may be thinking you are out of the market if you sell something at a loss. You would be correct, but you could still sell it at a loss and use the proceeds from selling to invest in a similar ETF. If you bought the same investment, you would have a wash sale, meaning you would not be allowed to take the loss. The wash sale rule says that you can’t sell an investment and rebuy an identical investment within 30 days or the transaction becomes taxable and the loss would be disallowed. 

Although tax rules are rarely black and white, many people point out that if you sold an ETF tracking the S&P 500 and then bought a different ETF tracking the S&P 500, you would probably run into the wash sale rule since it’s basically an identical investment tracking the same thing.

Instead, people might suggest selling the ETF tracking the S&P 500 and buying an ETF that tracked the Russell 1000. Both have large-cap companies in them and may have similar performance over time, but are not identical. You should consult with your own tax professional regarding tax advice. This is purely a hypothetical example.  

When the market is down, it’s a good idea to look for tax-loss harvesting opportunities and potentially rebalance. 

Consult with a Fee-Only, Fiduciary Financial Planner

If you are really worried about the stock market being down and tempted to make changes, it may be worthwhile to get a second opinion from a fee-only, fiduciary financial advisor. 

I am a fee-only, fiduciary financial advisor, so I have some bias here, but I’ve also seen it be helpful for people. 

Sometimes people only need to hear “Everything you are doing is correct. You are on the right path. Here are a few ideas that might make things a little better, but otherwise, you have done a great job.” Sometimes, that is enough to help keep them on track. 

Although it will cost money to hire someone to tell you that, the cost is likely small compared to the mistakes someone could make.

For example, if someone has $100,000 and decides to sell during a stock market decline and misses out on 50% returns in during a recovery, that’s $50,000. 

Even if a financial planner costs $2,000 – $5,000 to review your plan and investments, that’s small compared to $50,000. 

Sometimes a second opinion is what is needed to feel confident. 

Do Nothing

Another option during a stock market decline is to do nothing. 

I know that may seem weird, but sometimes doing nothing is the right course of action. Or should I say inaction? 

Most people are tempted to do something – to try to control every situation. 

When investing, sometimes doing nothing is more powerful than doing something. 

Sometimes you just need to wait and be patient. Sometimes it’s about avoiding the short-term noise.

The worst thing you can do during a stock market decline is panic and take action, such as selling stocks and sitting in cash. Every stock market decline has led to a recovery up until this point. 

If you sell and wait in cash, you are betting against something that has never happened.

I’m not saying it won’t happen in the future. It might, but I would guess if the stock market declines and never recovers, most of us likely won’t care about cash because there are going to be bigger problems in the world. 

You shouldn’t discount how powerful doing nothing can be. 

Summary – Final Thoughts

Stock market declines are a regular part of investing. It’s normal to experience a 10% decline in every single calendar year. It’s normal to experience a 20-30% decline every few years. 

As the old saying goes, “it’s a feature – not a bug.” 

If you expect declines to happen, it is usually easier to make smart decisions when they inevitably happen. 

The first action most people should take is to review their investment policy statement, or if you don’t have one, create it. What does it say you should do during these times? 

You can also consider buying the dip, but please remember, this isn’t a long-term strategy. This is just taking advantage of extra cash or scrounging up extra cash you may have. You may also see the stock market decline a few more times after buying the dip. That’s normal. 

You also can rebalance, assuming that is in line with what your investment policy statement says, and tax-loss harvest in brokerage accounts to help reduce your taxes. 

If you are still feeling anxious about the decline, consider hiring a fee-only, fiduciary financial advisor. Although it’s an added cost, the decisions you make during a stock market decline may end up costing you far more.

Lastly, consider doing nothing. Sometimes no action is better than action. 

Thanks for reading and good luck navigating the stock market decline!