How to Avoid Catastrophe in a Market Downturn | White Coat Investor

[Editor’s Note: This article originally published as one of my regular columns for ACEPNow and was written during the December 2018 Bear Market. That’s like two market crashes back. Since the information is pretty much evergreen and the market was down a bit recently, it seems like a good time to drag this out and publish it here. The tips, like most useful investing information, are just as practical now as they were back in 2018. ]

By The White Coat Investor

Q: The stock market is dropping, and the talking heads on TV are talking about moving to cash. Should I sell my stocks?

A: I have been writing this column for ACEP Now for nearly five years. In that period, the most significant U.S. stock market downturn was a 10 percent drop in early 2016. As I write this in December 2018, the stock market is down 14 percent from its peak in mid-September. By the time you read this, the stock market may have completely recovered from that loss, partially recovered from that loss, or fallen even further. Just like you and everyone else, I have no reliable way of predicting the future.

Financial writers often use the terms “correction” for a stock market drop of 10 percent or more and “bear market” for a loss of 20 percent or more. An avid student of financial history knows that, on average, a correction occurs about once a year and a bear market occurs about once every three years. Thus, having the value of your stock portfolio drop should not surprise the informed investor. This is what stocks do, and it’s part of the reason they provide higher long-term returns than bonds or cash.

The volatility should be insignificant for the long-term investor; however, if you are not investing for the long-term, you should not own stocks at all. Even a physician on the eve of retirement should be a long-term investor because some of the dollars saved for retirement will not be spent for two or even three more decades.

What you really care about as a stock investor is that the investment provides a solid return over the period you own it. So long as the return is good between the date you buy and the date you sell, the value at any time between those two dates is irrelevant to your financial goals.

Every investor is tempted to time the market, selling stocks when their value is high and buying them when their value is low. This is almost always a mistake. Timing the market successfully requires you to get both the exit and the reentry right and well enough to overcome the transaction and tax costs of the move. If you think you can predict future market movements, interest rate changes, and political events accurately, I suggest keeping a journal of your specific predictions for a year or two. If you are like most, you will quickly learn your crystal ball is cloudy. If you are not, perhaps a career change to hedge-fund management is in order.

The ultimate financial catastrophe for a stock investor is to sell low. Doing so late in your working career may prove irrecoverable, and physician investors who have done so often end up working an additional five to 10 years to make up for those mistakes. This is a financial error on par with not owning disability or malpractice insurance.

 

Three Suggestions to Avoid a Stock Market Catastrophe

I’ll give you three tips to help you avoid this catastrophe.

#1 Get a Financial Plan

Make sure you have a solid financial plan in place. Although the stock market as a whole will almost surely recover within a few months or years (on average, a full recovery from a bear market takes just 22 months), there is no guarantee any individual company or sector will perform as expected.

If you do not have a reasonably risky, broadly diversified low-cost portfolio, or worse, you are running the uncompensated risk inherent in picking stocks or sectors, this is a good opportunity to put a solid investing plan in place. If you fund your plan adequately, a boring old diversified portfolio of index funds should be adequate to reach your financial goals. If you are uncertain how to implement such a plan, seek out a fee-only, fiduciary financial advisor who offers good advice at a fair price.

#2 Tax Loss Harvest

Make lemonade out of lemons. Yes, you may have lost money. Don’t kid yourself that the “losses aren’t real if I don’t sell”. They are real. Money that used to be yours that you didn’t spend on a Tesla or a kitchen renovation in order to invest for your future really is gone.

However, you also now have an opportunity. If you are investing in a nonqualified (taxable) account, you can engage in tax-loss harvesting—that is, exchanging your investment with a loss for a similar but not substantially identical investment (in the words of the IRS). You can deduct up to $3,000 per year of losses from your clinical income, and the rest can be used to offset capital gains or carry over for use in future years.

Even if you have no investments in a nonqualified account, you now have the opportunity to buy low that investors always hope for. For example, in December 2018, you can buy stocks at November 2017 prices. In a particularly severe bear market, you may be able to buy at prices you haven’t seen in five to 10 years.

There is an old saying, “You make most of your money in bear markets—you just don’t realize it at the time”. When you look back as a retiree, you will realize the best returns on your investment dollars came from shoving money down the rat hole during a bear market.

#3 Sell Just Enough So You Can Sleep

If you’re not sleeping and you and your partner are fighting and you simply can’t take it anymore, try to exchange a major catastrophe for a minor catastrophe. Sell a little bit of your stocks for bonds or cash. In essence, sell to the sleeping point (ie, your comfort level). Then never go back to your previous, more aggressive asset allocation mix. You have discovered, like many investors before you, that your risk tolerance was not what you thought it was. You’ll need to save a little more money and perhaps work a little bit longer, but if reducing your stock market exposure by five to 10 percent prevents the financial catastrophe of going to cash at the bottom of a bear market, it will have been worthwhile.

Stock market downturns are expected events. By incorporating a plan to deal with them into your written investment plan, you can avoid bad investor behavior and reach your financial goals.

Did you sell in the last market downturn or did you following a financial plan and stay in the game? How did the decision affect your investing goals? Comment below!