Investors do not need to panic when a market downturn hits. It’s important to figure out the best strategy for navigating a losing streak. As always, there will be winners and losers in this volatile period.
You can transform your long-term performance by adopting winning strategies and avoiding losing ones right now. That is how.
Winner 1: “Dry Powder” Investors
It hurts to look at the value of your portfolio during a market downturn, but this is no time to bury your head in the sand. Corrections are great opportunities for investors who have cash to deploy, which is known as “dry powder” in the financial industry. Stocks have become much cheaper relative to the sales, cash flows, and dividends of the underlying companies. The recession is like stocks have gone on sale and it is the best time to buy.
Of course, it takes a combination of luck and foresight to develop that stack of cash. Most asset managers keep a portion of their portfolio in cash. The amount of cash tends to rise and fall with the manager’s opinion of the viability of the investment. Warren Buffet is have a huge amount of cash on Berkshire Hathawaybecause it determined that the stock has been overvalued relative to its fundamentals.
Investors shouldn’t have been out of the market entirely going into this latest recession. However, those who avoided getting caught up in the fervor should have some cash on hand to take advantage of the more attractive prices.
Winner 2: Dividend Stocks
dividend stocks They’re not immune to market downturns, but they tend to shine relative to other stocks during tough times. Corrections and bear markets are signs that investors’ risk appetite has diminished. Uncertain conditions cause capital to flow away from stocks and into other asset classes, such as bonds and cash.
Those same forces are also at work within the stock market. Growth stocks tend to take a beating, while dividend stocks hold up a little better. Companies that pay dividends also tend to have more stable cash flows and often avoid catastrophic interruptions during economic turmoil. It’s important to note that dividend stocks still provide returns in the form of quarterly distributions, even if their share price is temporarily low.
This is developing as we speak. the Vanguard High Yield Dividend ETF is up 2% year to date while major stock indices tumbled. Growth stock valuations have gotten a bit out of control and investors are looking for safety as prices fall towards historically normal levels.
Loser 1: Investors who sell
The only people who really lose during a stock market downturn are the investors who sell their shares. Gains and losses are not realized until they are settled through a sale. Any position with positive returns can still swing to a loss until that position is closed; the same is true for positions that are down.
In the history of the stock market, every recession has been only a temporary divergence from a long-term growth trend. If you sell during a recession, you are buying high and selling low. You are missing out on the opportunity to capitalize on growth when the market recovers in the future.
But investors sell for all sorts of reasons. Some shares are sold to cover distributions from retirement accounts. Sometimes circumstances change in a financial plan and assets must be liquidated to meet cash needs. Or a portfolio needs to be rebalanced to achieve a better mix of growth and volatility.
Too often, however, investors make decisions based on fear and leave the market due to the risk of losses mounting further. Selling into a recession may help you avoid the impact of a full-blown bear market if it goes that far, but that’s nothing compared to the opportunity cost of losing all future gains.
The best investors understand that volatility is inevitable and don’t scrap their entire investment plan when the market hits a rough patch.
Loser 2: Growth Stocks
growth stocks They are usually great tools for long-term returns, but they come with added volatility. They outperform when the market goes up and they underperform when the market goes down.
Stock prices are theoretically based on expected future cash flows, and growth stocks have more uncertainty surrounding those cash flows. It takes a major leap of faith to forecast the future earnings of a company that is expanding rapidly but is not making a net profit today. The rewards are great if the story comes to fruition, but the risks are also greater.
Valuations peak at the top of market cycles, and growth stocks tend to have the most aggressive valuations when investors’ risk appetite is high. That leaves more room to fall when the market falls.
This does not mean that investors should avoid growth stocks. Instead, he suggests that they should not be overexposed to this category, and should ensure that they are ready to withstand volatility when it inevitably arises.
This article represents the opinion of the author, who may not agree with the “official” recommendation position of a premium Motley Fool advisory service. We are motley! Questioning an investment thesis, even one of your own, helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.