How to keep your head in a collapsing market

published 16 October 2014

141016-markets — Now is probably not the time to sell

Another big, scary slide for markets yesterday.

At times like these it's easy to lose your head. One half of you is screaming sell!' and the other half is screaming buying opportunity!'

Take a deep breath. It's easy to forget in our world of copious money printing, but markets do sometimes go down as well as up.

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So today I want to talk about how to handle days like these...

There are only four things an investor can do

We've already been through the various reasons for markets falling. You can sum it up like this: America is about to stop printing money, and markets are worried that Europe won't pick up the baton.

Today I'd rather talk about how to deal with it. It's easy to panic at times like this, and feel you need to do something. Anything.

But when you boil it down, your potential actions are limited to four basic things. You can buy. You can sell. You can go short'. Or you can step aside and do nothing.

Let's deal with shorting first. When you see a market plunge by 300 points in a day, or whatever, it's easy to start thinking, "Oh, the fast cash I could have made by shorting that!" And for what it's worth, I can see markets falling further from here. We're still barely in correction territory for most markets a proper bear market (down 20% or more) is a while off.

But shorting is a tricky business. Good timing becomes much more important when you're going short. And that's hard.

There are plenty of short exchange-traded funds (ETFs)on the market (these are funds that go up when the underlying asset is going down). They're a safer way to experiment with shorting than spread betting is.

But you still need to treat them with respect. And if you do decide to go short, you must have an exit strategy this is not buy and hold' territory. These sorts of trades are measured in days, weeks and perhaps months but no longer.

So shorting is trading, and if you don't want to do that, you're left with buy, sell, or stay as you are.

Why now is probably not the time to sell

Let's take selling next.

Have a think about your portfolio for a moment. When you bought those holdings, were you thinking: "I am going to buy this asset until the price stops going up. As soon as the price stops going up, I am going to sell the lot".

Unless you're a momentum trader (in which case you should already have an exit strategy planned, you trend-following genius), then the answer should be no'.

I'm not saying that you don't own any dud assets. You probably do. We all make mistakes. But unless your original rationale for buying the asset has changed, then the fact that the price has gone down is neither here nor there.

By the way, this is why you must keep an investment diary of some sort my colleague Bengt wrote about this the other day.It's the only way to keep yourself honest to remind yourself of the real reasons you bought an investment in the first place.

The importance of asset allocation and rebalancing

So we're left with buying, or just standing aside. The nice thing about a market correction is that it gives you the opportunity to buy an asset that you want for a lower price than was on offer the day before. But how do you decide when to jump in?

This is where your asset allocation and diversification should come in handy. Asset allocation is all about knowing what you want to own, and what percentage of your portfolio you want to dedicate to it.

Let's say among other things you want to have 10% of your portfolio in cash, 5% in Japanese stocks, and 10% in UK stocks. If you look at your portfolio and find that the value of your Japanese stocks has fallen to below 5%, while your cash has gone above 10%, then you can adjust accordingly rebalance'.

If you invest on a regular basis, simply top up your Japanese holdings and reduce the amount going to cash that month. If you invest more on a lump sum basis, then set a mental trigger point if your asset allocation gets out of line with your ideal model by more than a certain amount, then rebalance.

The other thing to do is to look at your watchlist'. These are stocks and assets that you're tempted by, but have just been too expensive. This correction may offer you the chance to get in but only if they fall far enough.

You'll notice that all of these actions hinge on one thing having a plan in place. And if you don't already have a plan, don't pile in (or out) on a whim. Take some time to consider your ideal asset allocation and to set up a list of assets you want to buy. Now is as good a time as any to do it.

And if you're looking for a starter portfolio, you could do a lot worse than MoneyWeek's model investment trust portfolio. (If you're not already a subscriber, you can get access to the portfolio and get your first four issues free by signing up for a trial here.)

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.