What to Do In a Market Selloff

Do nothing. Well, almost nothing.

Have a Long-Term Horizon

If you are investing for a good outcome you should only invest money that you won't need for at least a decade, and if possible for several decades. Once you have that long-term horizon in mind the investing game transforms completely.

A short-term investor just sees market noise. Over the short-term the stock market is almost the same as flipping a coin. Here are the intraday moves of a stock (BAT). See how it just moves randomly up and down? Nobody can forecast those movements and if you day-trade you're just gambling not investing.

BAT Intraday Share Price

If you invest in a major stock index such as the FTSE 100 over decades the noise diminishes in importance and your equity return is dominated by upward drift. There are many bumps in the road which seemed like the end of the world at the time, but thinking long-term you can ignore them. As company earnings increase over time share prices gravitate upward to match earnings, as you can see for the FTSE 100 below over a 34 year period.

FTSE 100 Long-Term

Be Lazy

It is tempting to fiddle with your portfolio, but you should avoid doing so. Every time you trade you are reducing your return by incurring trading costs. Why would you voluntarily make brokers richer and yourself poorer? This means that indolence is a virtue for long-term investors. Before every trade you do consider:

  • Will this change increase the 10-year return of my portfolio?
  • Does this increase or decrease the risk of my portfolio?
  • If this increases my risk is this justified by the expected 10-year reward?

For long-term investors indolence is a virtue

Click to Tweet

Understand & Resist Your Cognitive Biases

The natural reaction when you see and hear news stories about stock market crashes is to panic and sell your investments. This is probably the worst thing you can do. Yes, prices are falling.

Ask yourself a simple question: you've sold, what next?

If you sell your stocks you will have cash sitting in your broker account earning nothing. At some point you will have to time your entry back into the market. When would you do this? Even professional investors are notoriously bad at timing markets. If instead you hold onto your investments you can ride out the storm without worrying about timing your re-entry.

The primary problem in a selloff is that we hate loss more than we like gains. In a selloff this means we are inclined to sell our temporarily loss-making position. This was illustrated nicely by Kahneman and Tversky, and you can read more about it here:

  • Why We Underinvest which explains the destructive bias of loss aversion and status quo bias and why we prefer consumption today rather than saving for the future.
  • High Returns from Warped Risk which shows how we boost low probability events, such as stock market crashes, and underestimate high probability events.
Kahneman Tversky Loss Aversion Utility

Rebalancing

Sometimes market movements will drive the value of your investments away from your long-term weights. This means you have to do something unnatural: sell some of your best-performing assets to buy more of your worst-performing assets. After or during a market crash this may mean selling bonds to buy shares which, with a short-term mindset, seems crazy.

With a long-term horizon this approach makes sense. If you look at the FTSE 100 graph above take a look at 2003 and 2009. At the time people were miserable and hated the stock market. Newspapers were filled with stories of pain and woe. And yet in retrospect these were good times to buy.

If you take our Asset Allocation course we discuss when and how to rebalance your portfolio and provide a spreadsheet to help you.

Have a Checklist

The aviation industry discovered long ago that the best way to ensure safety was to check the state of an aeroplane before every flight. The pre-flight checklist is almost like a religious ritual for pilots and has saved countless lives. If you want to reign in your impulsive tendencies and cognitive biases a checklist is a great way to ensure you don't act irrationally and keep your long-term goals in mind. We have provided a fund buying checklist which you can use, or use to create your own checklist.

During a market crash the most salient part of the checklist is to consider what effect selling your shares will have on your portfolio. Would the sale put the portfolio out of line with your long-term goal of capital appreciation? Does it create an imbalance with your long-term strategy? The answer to these two questions is almost certainly "yes" which should dissuade you from going through with the sale.

The important thing is to go through the checklist before every purchase or sale. This forces you to justify your action to your future, and more rational, self. It's also great for keeping a record of why you bought or sold which I can guarantee becomes fuzzy over the years. Sometimes this will happen:

"Come to think of it, the investment story hasn't changed so I'll stick with what I have and do nothing".

That's a long-term win.

Get our Latest Updates

Subscribe to get updates on our latest educational videos and blogs, how all the global shares, bonds and commodity prices are reacting, and upcoming economic data releases and how we think they will drive markets

February 6, 2018
ramin

Investment coach, financial author and founder of PensionCraft. Ramin wants to share his knowledge of how to succeed in long-term investment by keeping fees low, understanding behavioural investment pitfalls, knowing how to read macroeconomic indicators and understanding and controlling risk.