Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations.
Investing can be stressful. We all want to make the best decisions for our financial futures, but it can be challenging to respond to dramatic market conditions. In particular, many individual investors wonder how they should respond when the market goes south or strategists warn of a looming recession.
At moments like those, you may wonder whether it’s time to bail out of stocks and stock funds and go to cash. The answer to that question depends on which part of your investment portfolio you’re asking about.
For the portion of your portfolio that you tap into to pay current and near-term expenses—such as your son or daughter’s upcoming tuition bill—going to cash can make sense. After all, if you need to write a check for, say, $25,000 the first of next month, you can’t afford to have a balance of only $20,000.
And “cash” can be either literal cash, such as a bank account or a money market fund account, or short-duration bonds or bond funds, whose values tend to be cash-like stable.
But what about your long-term savings? What about accounts where you’re building up your retirement nest egg for a retirement that’s still five, 10 or 20 years away—or even further off in the future? For that long-term portion of your portfolio, going to cash is the wrong answer.
Should You Sell When Stock Prices Are Falling?
Why is going to cash the wrong move with the long-term portion of your portfolio? Why not sell off stocks and stock funds to avoid losing even more money?
Even calloused veteran investors feel the pain when their portfolios plunge into the red. But losing value and losing money are not the same thing. Losses aren’t real until you sell.
Some investors believe that by selling during a downturn, they can wait out difficult market conditions and reinvest when the market looks better. However, timing the market is extremely difficult, and even professionals who attempt to do this fail more often than not. That’s especially true with funds.
Sell High, Buy Low?
In trying to time markets, investors—especially investors who rely on funds, like typical savers with retirement accounts—typically end up selling when prices are at a low, locking in losses. They lose again by still being out of the market when it rallies.
That’s because the births of rallies tend to be abrupt. And it’s because individual investors tend to hesitate to get back into the market. They’re afraid that newborn rallies are false starts, which investors have long derided as dead-cat bounces.
Numbers don’t lie. In the pandemic fraught year of 2020, the average stock investor gained 17.29%, according to the Dalbar Quantitative Analysis of Investor Behavior report. Not a bad gain. But not as good as the market itself, which gained 18.40%.
That gap got worse in 2021. In the first six months of that year, the average stock investor’s investments gained 15.25% in value. But that lagged the broad market’s 17.36% advance.
Why the gap?
Individual investors’ efforts to time the market are often bad. They tend to sell low and buy high. And their judgment is bad too. Their bad bets on the market are often much bigger than their good bets. That’s “strong evidence that the dollar volume of incorrect guesses is the culprit,” Dalbar Chief Marketing Officer Corey Clark says.
Learning to Live With Volatility
After every market decline, no matter how steep, markets have recovered. So do well-diversified investment portfolios. So, darting in and out of the market is unnecessary, and it hurts your portfolio.
Market volatility is a fact of life in the stock market. Experts say you must learn to live with it. At least reduce its impact enough to make it bearable.
When the dot.com bubble burst at the beginning of the twenty-first century, the S&P 500 Index lost nearly 50% of its value. Then, the Great Recession of 2007 to 2009 saw the S&P 500 lose nearly 60% of its value. Finally, the Covid-19 pandemic sent the S&P plummeting in March 2020. Within a month, the index was down by 34%.
But each of those declines—and every additional bear market—was followed by a rally. The S&P 500 has not only rebounded but gone on to reach record highs. Bear markets since 1929 have averaged declines of 37.3%. But the following bull markets since 1921 have averaged climbs of 164%, according to Sam Stovall, chief investment strategist, CRFA Research.
The conclusion is clear. The market rewards investors who have the discipline to remain invested over time.
Maintain Discipline in the Face of Volatility
The benefit of maintaining discipline and sticking to your strategy as markets fluctuate is clear. But for many of us, what we know to be correct and what we do are two different things.
Research shows that the pain of losing money is stronger than the pleasure derived from gains. Emotions and cognitive biases exert a strong influence that can be very difficult to overcome. But there are steps you can take to help strengthen your resolve as markets gyrate.
Define Your Goals and Create a Financial Plan
For most investors, the most important long-term financial objective is saving for retirement. Other longer-term objectives might include saving for college for children or grandchildren. A shorter-term goal might be buying a house or starting a business venture.
Financial goals are unique to every individual and may vary based on life events. But stocks are the principal driver of long-term returns in your portfolio, and it’s important to maintain discipline if you want to reach your goals.
Establishing and adhering to a financial plan is the best way to achieve your objectives. It’s hard for many investors to resist the impulse to sell during periods of economic stress and market volatility. But it’s vital to stick to your long-term plan.
One of the best ways to stay on track is to work with a professional financial advisor, who can help you create a plan and stay the course when the going gets rough.
Understand Your Risk Tolerance
Your financial goals, time horizon and risk tolerance are key factors in creating an investment plan.
Of the three, risk tolerance can be the trickiest to nail down. It describes the amount of risk you’re willing to take to achieve a particular level of return. But doing that is essential. The more risk you’re willing to take with your investments, the higher your potential return.
Further, knowing your risk tolerance helps you create a portfolio that grows without subjecting you to more market volatility than you can stomach. And portfolio growth is how you build value. It’s the linchpin of creating an account that can pay for your goals, whether those are retirement, education, travel, housing or anything else.
What to Do When You Need Help With Your Investments
If you can’t define your risk tolerance or how it fits together with your goals and time horizon, a financial advisor can help you. They know which questions to ask. They know how to help you challenge your own assumptions to vet them or amend them.
If financial decisions make you anxious and the thought of seeing your portfolio decline in value during down markets gives you heart palpitations, it’s important to recognize that and take steps to manage your reactions and maintain discipline.
A qualified financial advisor can help, as can a portfolio constructed to weather different types of markets. A discussion in advance of market stress can lead to strategies to follow when volatility strikes.
Focus on Asset Allocation
A quick look at the historical performance of the S&P 500 demonstrates that equities are vital to achieving long-term financial objectives.
Take the 30 years that ended with 2022. In that span, stocks averaged nearly two and a half times better yearly performance than bonds, as the graphic above shows. Stocks—represented by the S&P 500—averaged an annual gain of 11.25%. Bonds—represented by the Bloomberg US Aggregate Bond Index—averaged a far more modest 4.7% gain.
Stocks outperformed bonds in 22 of those 30 years. If you invested $10,000 at the outset, by Dec. 31 of last year, your balance would have ballooned to more than $158,000 in a hypothetical S&P 500 Index fund that charges no expense ratio, inside a tax-deferred retirement account.
Invested in a comparable, hypothetical no-fee, no-tax Bloomberg Agg bond fund, your ending balance would have grown to about $38,000. The lesson? A reminder that stocks grow much more than bonds over time.
Using Bond Funds as Shock-Absorbers
Still, including bonds—realistically, bond funds make it easier—is a good idea. Why? Diversification can go a long way toward helping you achieve your objectives while managing risk and volatility. Diversifying your portfolio can provide insulation against a falling stock market.
An allocation to fixed income is part of a standard diversification strategy, but bonds typically offer lower returns than equities. An allocation to alternative investments like real estate, which tends to do well when stocks are performing poorly, can also benefit your portfolio.
Look again at the graphic above. It shows how stocks in the form of the S&P 500 Index typically grow much faster than bonds do. But you can use bonds as a shock absorber to reduce a portfolio’s overall volatility. That’s especially helpful if you want to dampen your portfolio’s potential rollercoaster ups and downs in individual years, caused by stocks’ volatility.
Benefits of Diversification
A mix of 60% stocks and stock funds plus 40% bonds and bond funds is a popular way to harness the growth potential of stocks with the calming influence of bonds. Of course, you can adjust the mix to suit your—that’s right!—risk tolerance.
The key is to construct a portfolio using a variety of assets whose performance is not correlated. Within your equity allocation, you can further diversify by boosting your weighting in defensive stocks. They tend to grow less than go-go technology stocks, for example. But they also tend to give a smoother ride because they’re more insulated against market ups and downs.
Best Way to Build Long-Term Wealth
Investing in the stock market can be stressful, but there’s no better way to build wealth over the long term.
Since 1926, large-cap stocks like those in the S&P 500 Index averaged an annual return of more than 10% through July 31. Small-cap stocks have averaged nearly 12%. In both cases, those gains were despite periods of volatility and downturn such as the Great Depression, World War II, the dot.com bubble burst and the Great Recession.
It may be harrowing to watch your portfolio decline in value in the short run. But resist the damaging urge to sell when times are tough. History shows that the market rewards disciplined investors.
