The worst mistakes to avoid in a market downturn

The worst mistakes to avoid in a market downturn

Joseph Darby

Four mistakes to avoid during a market downturn, and what to do instead

Following a decade-plus of generally positive investment markets across the globe, a significant downturn among share markets is finally upon us.

Here at Become Wealth, we don’t pretend to know how bad the downturn will be or how long it will last, however, we do know that some investors will make costly mistakes before values rise again.

Here are the four most common financial errors that occur during market downturns, and what you can do instead of falling into these traps.

Mistake 1. Overreact and miss the opportunity

In times of falling investment values, some investors overreact by selling riskier assets and moving to safer assets – even if this just means shifting KiwiSaver fund choice from “Growth” to “Conservative”. In this example, within the KiwiSaver Scheme itself the provider would basically end up selling assets like shares and replace them with safer assets such as fixed interest.

More hands-on investors may also embrace familiar investments, perhaps moving from international to domestic investments – this reduces diversification and is sometimes called “home bias.”

It’s a mistake to sell risky assets because of fluctuating values (volatility) in the belief that you’ll know when to move your funds back to those assets. To explain in more detail, we’ve got an entire webpage dedicated to why attempting to time the markets is a bad idea.

Selling – including changing KiwiSaver fund choice – during a down market, not only locks in losses, but also puts investors at risk of missing the market’s best days. There’s no proven way to time the market—targeting the best days or moving to the side-lines to avoid the worst—so history argues for staying put through good times and bad.

For example, the Bank of America analysed data going back to 1930, and found that if an investor missed being invested during only the best 10 days in each decade, their total return would be just 91%, significantly below the 14,962% return for investors who held steady the whole time. (To determine this, they tracked the S&P 500, which is the most common performance measure of the largest stock market in the world). Crucially, the research also found that the “best days generally follow the worst days for stocks”.

Stock prices suffer during financial downturns, but they typically recover over time.

The graphic below has been reproduced with permission of global investment research powerhouse Morningstar. It illustrates the cumulative returns of an all-stock portfolio after six historical U.S. downturns. In the short term, uncertainty from such external shocks can create sudden drops in value. For example, the all-stock portfolio posted a negative return in the month following four of the six analysed downturns. However, over longer periods of time, returns were much more attractive, and investors who stayed the course, obtained considerable rewards. (Also keep in mind that most people aren’t all invested in shares, for instance, a usual KiwiSaver balanced fund may only have a 50 percent share allocation).

The lesson here is that patience pays.

Cumulative return of all-stock portfolio after various events
Cumulative Return of All-Stock Portfolio After Various Events
Attribution: Morningstar.

What to do instead:

Stay calm and stay invested!

Always use caution when making decisions about the future. One of the good things to emerge from times of uncertainty is it can help us all keep things in perspective – we can focus on the things that really matter most, such as our hopes and dreams for the future. This is where having a plan can help you stay on track and head off some of the anxiety that may accompany a downturn.

Mistake 2. Fail to plan

Investing without a plan is a mistake that invites other errors, such as chasing performance, trying to time the market, or reacting to news stories and “media noise.” Such temptations multiply during downturns, as investors who look to protect their investment portfolios may seek out what they think are quick fixes.

This means that if you’re 30 years old and won’t access a KiwiSaver Scheme investment for many decades, what investment markets are doing this year or next probably isn’t a concern.

What to do instead:

Several things, including:

  • Make a plan, then stick to your plan. Developing an investment plan doesn’t need to be hard – you can start by answering a few key questions about where you are now and where you want to be in the future. If you’re not inclined to make your own plan, one of our financial advisers can help.
  • Remember your time horizon. This is how long you have until you intend to access an investment. For example, if you’re accumulating a deposit to buy your first home, that could be a short or medium-term investment timeframe, while a person investing for retirement is often thinking over a much longer timeframe and can accept a lot more volatility (short term changes in value) to achieve a better overall multi-decade outcome.

Mistake 3. Fixate on losses

“Everyone has a plan ‘till they’re punched in the mouth” – Mike Tyson

Let’s say you have a plan, and your portfolio is balanced across different asset classes and diversified within them, but your portfolio value drops significantly in a market upset. It’s natural for emotions to bubble up during periods of volatility, as it’s not nice to see investment values plunge in value by 10%, 20%, or even more.

But, watching the stock market or your own investment values too closely can soon turn into an emotional roller coaster. Binge-watching your investment values won’t help them recover!

What to do instead:

Those investors who can tune out the news and focus on their long-term goals are better positioned to keep trucking with a wise investment strategy.

It pays to accept that investment downturns are normal, and most investors will endure many of them through their investing life. Remember: this is how share markets work. Since 1950, major investment markets have dropped by 10% or more dozens of times. It tends to happen every few years and can be brought on by events such as:

  • natural disasters,
  • world wars,
  • outbreaks, and
  • various other events which lead to economic turmoil.

Sometimes such events are short-lived; other times they mark the beginning of a recession that can last several years. Still, every decline in the past has been followed by an eventual recovery, and stock markets have gone on to hit new highs.

The best practical step to take may be the easiest: avoid looking at your investments, including KiwiSaver. To assist, some people may even need to lock themselves out of their online app or login!

Still not convinced? Here are some words of wisdom from well-known billionaire and investing expert Warren Buffett, who explains why savvy investors aren’t rattled by market downturns:

“If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the [stocks] they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

Ideally, those great investors will have a little cash on hand to snap up great investments at bargain prices.

Mistake 4. Drop your guard and forget about other aspects of your personal finances

Give some thought to this comparison: when we’re driving and see an accident or issue across the motorway or road, we are naturally drawn to slow down, fixate on the issue, look, and try to figure out what happened. Maybe this is related to the survival instinct. We might wonder things like: What happened? Have we ever done something similar? If it’s an accident, are people hurt? Badly?

This phenomenon is sometimes called rubbernecking, and although it’s understandable from a human nature perspective, rubbernecking is well known to cause more traffic accidents.

Circling back to investments, given the media headlines, email topics, and social media posts we’re all currently being bombarded with, it might be easy to forget about the big picture – including other aspects of your financial life. Neglecting one or more of these areas could be a recipe for disaster.

Related material:

What to do instead:

Ensure you keep in mind non-investment aspects of your finances, such as:

  • Maintaining enough of a “rainy day stash” tucked away to meet any contingency expenses that might arise such as fixing a car or washing machine – this is sometimes called an emergency fund,
  • Keep paying off any high interest debts such as car loans and credit cards,
  • Keeping a wary eye out for Covid-19 related scams,
  • Purchasing private health insurance if you don’t want to rely on the public system, and
  • Ensuring you’re protected if you were to become ill and unable to work for a protracted period.

The bottom line

Here are the four mistakes to avoid during a market downturn:

  1. Overreact and miss the opportunity
  2. Fail to plan
  3. Fixate on losses
  4. Drop your guard and forget about other aspects of your personal finances

As always, if you’d like to discuss any of the ways to avoid these mistakes then our advisers would be more than happy to assist. Just get in touch to book your complimentary initial consultation.

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