In physics, the most basic rule of gravity is this: What goes up must come down. But when investing, what goes up may come down again.
When you buy securities, you aim to make money. But unless you’re able to see the future, losses are something you’re bound to encounter at some point.
So, what do you do?
Understanding Market Volatility
If you’re new to investing, know the market moves in cycles. Sometimes up, other times down. This is referred to as market volatility. It’s unpredictable and different factors can contribute to it, ranging from rising inflation to a global pandemic.
When volatility sets in, it might resolve quickly or linger for weeks or even months. Higher volatility means more risk while lower volatility may mean a less risky market environment. As an investor, there’s little you can do to control market volatility — but you can control your reaction to it.
The Dangers of Emotional Investing
Volatility can be stressful, so it makes sense it can lead to emotions (instead of thoughtful decisions) driving your investing approach. But when managing losses in a portfolio, it’s particularly important to avoid emotional investing.
If you’re worried about how losses could affect your portfolio, be aware of the following emotional biases and how they can influence your investing:
- Loss aversion: The goal is to avoid further losses. You may end up holding onto a stock that’s losing money rather than selling it, in the hopes of regaining its value.
- Overconfidence: When you assume you know more about the markets than you do. When this happens, you may end up overestimating a stock’s return potential, which can lead to disappointment and even selling at a loss.
- Endowment effect: Creates an emotional mindset in which you hold on to assets because you think they’re worth more than what they are.
Read more: Five Mental Hacks for Investing
How Investors React to Losses
Giving in to emotional biases can lead to missing out on buying opportunities or unintentionally amplifying your losses.
The challenge is, as the song goes: “You’ve got to know when to hold ’em, know when to fold ’em” to minimize losses. If volatility is on the rise, here are three strategies you can employ:
If stock prices start to tumble, selling puts the brakes on losses. But in the long term? When market volatility increases and stock prices drop, panic selling can happen. If you follow the crowd and sell, you may lose money if the stocks you sold off rebound relatively quickly.
If you’re able to set aside emotion, you may consider buying more stock at a discount when prices drop. For example, if a stock you’re invested in normally trades at $50 a share and dips to $30 a share, you can buy it at a 40% discount. If volatility eases and prices climb again, you could sell and reap the benefits. But know you’ve taken on more risk, since there is no guarantee the stock will recover.
Here, you’re taking a wait-and-see approach to see what happens. If volatility eases relatively soon after a drop, then any losses you realize may be quickly erased by gains. If the stock continues to slide, you could decide it’s prudent to sell.
What You Can Do to Manage Losses
Losing money isn’t pleasant. But the more attuned you are to your appetite for risk and investing goals, the easier it becomes to navigate volatility.
Gauge your comfort zone.
Establishing a baseline or upper limit for acceptable losses can help you decide whether it makes sense to sell, buy or hold. Yours can depend on several things, including:
- Your personal trading strategy
- Your age and investment time horizon
- Risk tolerance
Consider stop loss orders.
Stop loss orders may help limit losses and eliminate the possibility for emotional decision-making to take over. With this order, you tell your brokerage to buy or sell a security once it hits a certain price point.
Pro tip: Once you have a stop loss order in place, resist the urge to tweak it. If you’re constantly fiddling with the price point at which a security should be sold, it could leave you open to bigger losses.
Consider a more automated approach.
Robo portfolios may be a good tool to help you build wealth and potentially limit losses. With robo portfolios, like ours at Ally Invest, you invest in a group of securities that have been selected for you based on your risk tolerance, goals and strategy. It leans on what matters to you and a cash buffer helps shield you from volatility.
The advantage of this approach is that your portfolio is managed for you, so there’s no opportunity for emotion to creep in and cause you to sell off assets in a panic when the market experiences a downward turn.
Managing Through Loss
The market will go up and down, but what’s important is what you do during those swings. You can minimize loss by developing an individualized approach to your investing, based on the financial outcomes you’re aiming for. The volatility may still be stressful, but your investing strategy can help you ride the wave.
Our interest-earning cash cushion may help protect you against volatility.