Managing Emotions During a Market Decline – The Importance of Having a Plan
Many investors are starting to feel uncomfortable watching their investment portfolios decrease in value as markets continue to decline from the November 2021 highs. A review of past market corrections can provide us with some general guidelines to help manage expectations. How much more selling is yet to come, however, and how long it will take for the markets to turn around is still largely unpredictable.
Markets continuously move in waves or trends within an economic cycle (Illustration A). Sometimes the up trends are substantial, with small, seemingly insignificant moves lower, and other times, such as the 2020 pandemic related drop and present day, the moves lower may be significant. While it is important to understand that the general trend of the markets have been upward historically, unfortunately down trends can last an uncomfortably long time. So, what do we do when markets – and our feelings about our investments – are trending lower?
First, we must understand that these “ups and downs”, and the associated emotional cycles, are a normal part of investing and impossible to perfectly time for even the most experienced investor.
Illustration B depicts the emotions that investors go through during an investment market cycle. When they review the increases in their investment statements as markets move up, they’re happy. However, as markets decline many investors will go through different emotional states. The feelings of joy when investment values were increasing are replaced by negative emotions as the market falls. These emotions typically start as anxiety, which may become panic, anger or even depression.
Although it can be difficult to resist during a market downturn, one of the biggest mistakes an investor can make is to panic and sell at a time when you should be buying. Understanding this is the key to success when investing as part of a life long financial plan.
As the markets go down it’s important to have a plan, keep calm, carry on, and remember the number 1 rule of investing: Buy low and sell high.
The Relationship between Investment Gains and Losses
Investment gains are not equal to losses, emotionally or mathematically. To understand the relationship between gains and losses, one only needs to look at Illustration C , which reflects the return required to offset a related loss.
As you can see in Illustration C , investors can withstand small losses to their portfolio, as the gain to get back to breakeven is similar to the loss incurred. However, once you start losing 30% – 50%, the required gain just to get back to breakeven becomes significant.
Many investors saw their portfolios drop in value 40% – 80% in 2000 – 2003 following the aftermath of the ‘dot com’ internet bubble. For those unfortunate enough to lose 80%, they needed a 400% gain just to break even.
In 2008, during the market decline brought on by the banking crisis, the TSX Composite Index and the S&P 500 Index both dropped over 50% from their previous highs. Investors in that situation required a 100% return to break even.
We know that capital preservation is the key to successful investing. When portfolios go down less than the markets, calm investors with a plan can capitalize on the recovery. So, risk management must be at the core of any wealth management strategy.
Croft Invests with a Market Cycle Mindset
At Croft Financial Group, we look at these market waves and see opportunity. We look at the facts, we do the math and we develop a plan on how to react on market downturns. We believe that knowing where we are within the current market cycle (Illustration D) is one of the greatest predictors or influencers of what the market is likely to do in the future.
At Croft, we look for market extremes, as this knowledge can help us increase or decrease our aggressiveness or defensives in a timely fashion.
With that in mind, we cannot predict every small downturn in the market. However, we do strive to manage portfolios well, both to protect client assets from significant downturns and, when the markets resume their uptrend, investors are holding good assets that are well positioned to capitalize on the recovery and related opportunities.
When we apply this process, it’s about stacking the odds in your favour. It’s about having a plan, it’s about increasing the probabilities of our investment decisions being right, and it’s about positioning your portfolio correctly to take advantage of stock market cycles and related volatility (Illustration E).
Understanding the importance of knowing your individual Risk Tolerance
Risk Tolerance is a measure of your willingness and ability to take on risk. Interestingly, a person rarely knows where their tolerance lies until faced with a market correction. Unfortunately for many, an overestimation of risk tolerance can result in anxious days and sleepless nights. which is why at Croft we check in regularly to ensure our clients are invested appropriately to their risk tolerances and remain comfortable in staying the course.
It’s important to realize that Risk Tolerance is more of a range than an exact number. Your ideal range would be in the green zone as seen in Illustration F , but your comfort level may differ from other investors. Some are comfortable with a higher exposure to risky assets (higher volatility) whereas others want to hold less risky assets (lower volatility).
Depending upon your unique circumstances and objectives, you may increase or decrease your exposure to riskier assets, knowing you may be uncomfortable at times, either because you are missing some of the market upside or you are experiencing a market decline. In either case, it’s about staying the course to meet your financial goals.
In general, portfolios holding a higher percentage allocation to stocks, which could be considered riskier assets, tend to produce a higher rate of return over the long term. As we know, however, this quest for higher returns can come with an emotional cost. Some investors are well suited to cope with higher portfolio volatility for the promise of greater gains, while others are prepared to accept lower returns, preferring to avoid higher portfolio volatility and the associated emotional roller coaster ride.
Regardless of your risk tolerances and objectives, it’s during these down cycles that we need to stay calm, patient and prepared to tolerate the shorter-term pain for longer-term gains with as few sleepless nights as possible.
At Croft, it is our job as your Portfolio Manager to ensure you remain invested according to your comfort level and well positioned to meet your objectives, which can change from time to time. If there have been any changes to your risk tolerance or financial circumstances, please reach out to us directly to schedule a conversation.