In a Falling Market Should You Cut Your Losses or Dig in Deeper?

Over the last year or so, almost every evening on my way back from office, I would meet Mr. Pathak sitting along with his group of friends under our building discussing the stock market.

As I passed them, I would often hear them dole out tips and advice on what to buy and sell.

But since the last few weeks, the gang seems to have disbanded.

And it's not just Mr. Pathak and his group of friends. As stock markets around the world crashed in recent weeks, leaving investors poorer by trillions of rupees, both investors and so-called 'experts' have been left dumb founded.

Everyone seems to know exactly what to do when markets are booming. But when markets fall, investors often indulge in panic selling, hiding out in cash, or end up trading frantically.

They make several mistakes that can hurt them in the long-term.

A lot of experts list things to be prepared for when the stock market crashes but what must investors do after it actually does?In a falling market, should you sit tight and do nothing, cut your losses or should you add more stocks? Read on to find out more...

Investment Time Horizon

Choosing the right stocks is no simple task. But the investment time horizon is equally important.

One of the biggest mistakes an investor can make is not aligning the timeline of their goals with their investment in stocks.

Before we talk about what an investor must do in a falling market, it's of paramount importance that one understands the importance of the time horizon first.

Investment time horizon refers to the amount of time an investment will be held before the money is needed back. Time horizons can help decide the type of stocks you choose to invest in your portfolio.

As the time horizon gets longer, an investor can choose to increase the risk in his portfolio. If the stock market is falling like in the current scenario, a longer time horizon allows more time for the portfolio to recover.

Time horizons can be subjective as per investors needs and goals but we could classify them into three periods: short term, medium term, and long term.

Short-term horizon is anything less than three years. When markets crash, this timeframe could be too short for a portfolio exposed to high-risk stocks to recover.

Medium-term time frame is between three to seven years. With this time horizon, an investor can hold on to riskier stocks and allow one's portfolio to grow without being overexposed to risk.

Long-term goals are generally more than seven years. Over such a long time period, an investor could stay invested in high growth stocks for a higher potential return.

Even in a sustained bear market, the investor would have enough time to weather the storm and hold on to his portfolio.

And just like all things related to the markets, time horizons are also dynamic and constantly changing.

An investors time horizon could shift with age, new goals or a change in financial situation, etc. It's even possible to have multiple time horizons at the same time.

It could be an investor saving for retirement while simultaneously saving to pay for his daughter's college fees or to buy a second home.

Hence, time horizon is the principal constituent on the basis of which one can determine whether to sell existing investments or add to the portfolio in a falling market.

Cut Your Losses Short

In a falling market, especially when the market is heading into a major correction, investors must remember the all-important rule: Cut Your Losses Short.

No investor wants to sell for a loss. Accepting failure is painful and difficult. But to become a successful investor, you must set your ego aside, take a small loss and still be fit enough, both financially and mentally, to invest again.

Cutting losses quickly prevents you from suffering a devastating fall that's too steep to recover from.

And it's not just us saying it. Consider this...

Assume you buy a stock at Rs 100 and it drops 10% to Rs 90 during a market fall. You quickly cut your loss and move on. Now to reclaim that loss, you need to make an 11.2% gain on your next purchase with your remaining capital, which shouldn't be hard to do.

But what if you didn't sell? What if the market fall continues and your stock falls to Rs 50?

To recover a 50% loss requires a 100% gain. How many stocks do you think double in price?

This doesn't mean you should sell off all your investments when the market is falling. Such a move can result in missing out on potential gains when the market bounces back.

Instead, analyse your portfolio for risky, low-grade stocks with a history of volatility or a new business model and sell off these stocks to reduce the risk.

It's common for investors to hang onto losers too long because they believe those stocks will rise again.

And this is not really unusual. Just like people have favourite watches or shoes, some investors have favourite stocks which they are unwilling to let go even if it continues to erode capital from their portfolio.

Investors would be better off selling stocks doing poorly in the market and holding onto stocks that are rising because they are better positioned for the current environment.

Booking losses in these weak stocks would also be a good opportunity from a tax perspective and could be used to offset against future gains to improve long-term tax efficiency.

Stay Calm & Hold On

Long-term investors know that the market and economy will recover eventually and rebound.

Holding on to stable investments in established companies can pay well if you can stay put until the market gains strength again.

During the 2008 financial crisis or the recent 2020 pandemic, the market plummeted and many investors sold off all their holdings.

However, the markets bottomed quickly and eventually rose to its former levels and well beyond.

Panic sellers may have missed out on the market rise, while long-term investors who remained in the market eventually recovered and fared better over the years.

Suppose an investor purchased TCS stock in January 2006 and is holding it.

During this 16-year period, he would have experienced the 2008 global financial crisis, the 2015 sell off, the 2020 pandemic as well as the recent sell off this month.

Yet, today his total investment would have grown by 1,534%.

Over a sufficiently lengthy period, even the biggest drops look like mere blips in the market's long-term upward trend.

Unfortunately, in a falling market, investors tend to sell their winners too early because they worry those stocks will decline. It makes more sense to hold on to strong companies during such times as they tend to bounce back.

Buy Strength, Not Weakness

We have all heard of the thumb rule of the stock market: Buy Low and Sell High. In case of a falling market, you can buy more stocks at lower prices. But you cannot just buy stocks blindly only because they are at a low price.

One needs to have patience do solid research on the company. In a falling market, the right strategy is quite simple. You have to buy strength, not weakness.

Most of your fresh buys must be into stocks and sectors showing strength. Allocate only a small portion to fundamentally sound stocks which have fallen considerably but represent good value.

When markets recover, it's really these strong stocks which would deliver positive returns even in a bear market while the weaker stocks would remain in the red and probably even go lower.

Investors could also follow the 'Cost Averaging' strategy, where one can invest a designated amount every few days or weeks into such strong stocks.

As the market continues drifting lower, you would be able to buy more shares for the same amount of money.

In the long run, this strategy can lower the average price of the shares you own and can fetch higher gains when the market regains traction.

Final Words

Investment losses are painful, but if investors can stay focused on their goals, rather than obsessing over daily account statements, they would be better off in the long run.

Chaos and high volatility should not be a worry for long-term investors. If one wants to buy stocks, look for value stocks. They are less volatile and fairly immune to inflation in the current scenario.

In theory, selling your stocks right before an expected market crash is a smart strategy. You would be selling when prices are still high and you can reinvest once prices are much lower.

But in reality, it's practically impossible to do this because it means one must get the timing perfectly right not just on the selling part but also when buying back at the right price before markets turn back and move higher.

If you sell all your stocks and hold on to cash, you not just risk losing on profits if you sell too early but if you wait too long to get back into the market, it may have already advanced considerably.

It makes sense to hold on to your investments for the long term if possible as no matter how severe a crash is, you don't lose any money on your investments unless you sell.

The key is to invest in stocks with strong fundamentals. Not all companies can pull through difficult times.

However, by investing in companies with strong underlying business fundamentals, your investments are more likely to recover.

It's prudent to know your risk tolerance beforehand and choose stocks accordingly. This way, you won't panic during a market crash.

Happy Investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...