Top 5 mistakes investors make in a market sell-off

E*TRADE Capital Management in collaboration with Morgan Stanley Wealth Management

05/18/22

Summary: Whether it’s panic selling, hiding out in cash, or making knee-jerk decisions in volatile markets, these behaviors can hurt investors in the long term. Learn how to spot—and avoid—common mistakes.

There’s no doubt about it: market sell-offs are unsettling. Seeing your account value decline can cause even level-headed investors to second guess their strategy. The fact is that periods of volatility are not uncommon and should be taken in stride. During these times, it’s important to recognize common investing mistakes—and know what to do instead.

1. Panic selling

It can be gut-wrenching to see your investment portfolio or the 401(k) plan that you’ve been building for years take a sudden dive. The urge to cut your losses and wait for the dust to settle can be overwhelming. Ironically, this can be the single most damaging thing an investor can do.

Selling into a falling market ensures that you lock in your losses. If you wait years to get back in, it can be hard to fully recover.

Instead, try this: Take the long view. If you don’t need cash right away and have a well-diversified portfolio, realize that downturns ultimately tend to be temporary. The market may sometimes feel like it could go to zero, but history has shown that rebounds can return many portfolios to the black in due time.

2. Moving to cash and staying there

This mistake intensifies the damage from panic selling. Take, for example, the 2020 pandemic-induced market downturn. The strong rebound in stock prices just weeks after their March lows is a good example of how bailing out can cost investors when the market reverses direction and they are still sitting in cash.

S&P 500: 1/1/20–6/30/20

Chart displaying S&P 500 data from January 1, 2020 to June 30, 2020.

Source: FactSet Research Systems


Instead, try this: Investors who have more cash than their long-term strategy calls for because they sold during the market slide, or for any other reason, should look to close that gap and get invested. Dollar-cost averaging, a method of automatically investing the same amount at regular intervals (say, monthly) to get back into the market gradually, can be a good way to get there.

Dollar-cost averaging reduces the sensitivity of your portfolio to the luck of timing, which can make it easier for anxious investors to move out of cash, since they can avoid the worry of putting a big chunk of money into the market, only to have the sell-off resume. And if the market rebounds, they will be glad that they already put some of their money back to work, rather than having all of it on the sidelines.

3. Not recognizing your own strengths and weaknesses

Many people tend to overestimate their ability to judge when an investment is a great deal at a certain price. They might compare the price of a stock that’s been beaten-down to the much higher price it used to trade at and consider it an opportune time to buy.

But stocks that undergo wrenching losses often do so for fundamental reasons, and the possibility they still have further to fall is considerable. This practice of buying into a down-trending market is known as “trying to catch a falling knife”. Profiting from short-term trading is a lot more difficult in practice than it seems.

Instead, try this: Know that, in times of market uncertainty, you don’t have to go at it alone. E*TRADE and Morgan Stanley have educational resources plus thought leadership and commentary on the latest market happenings. Or consider talking to a professional who can go through your portfolio with you and help you understand how to proceed, based on your time horizon and risk tolerance.

4. Holding on to losers

Most people don’t like selling investments at a loss. This can cause them to hang onto losers too long believing those stocks will rise again, and to sell winners too early worrying those stocks will decline—what is known in behavioral finance research as the “disposition effect.” Often, investors would be better off selling stocks doing poorly in the market and holding onto stocks that are rising because they are better positioned for the current environment.

Instead, try this: Consider tax-loss harvesting. If losses arise in a taxable investment account, “harvesting” them by selling those positions can improve long-term tax efficiency. Also, many investors may be better off converting at least some of their retirement savings from a Traditional IRA to a Roth IRA. Since there are tax consequences, doing a conversion when stock values are depressed may potentially increase tax benefits over the long-term.

5. Forgetting to rebalance

During a major market decline, a portfolio’s asset allocation to equities tends to decrease substantially, as stocks sell off and bonds rally. Forgetting to rebalance back into equities may extend the amount of time a portfolio takes to recover from market downturn.

Instead, try this: If you’ve decided on a rebalancing plan, stick to it. Studies have shown that rebalancing tends to improve risk-adjusted returns over time (as long as it doesn’t generate excessive tax and transaction costs) by reducing portfolio sensitivity to the timing of up and down markets.

Tools like E*TRADE’s Portfolio Analyzer (login required) can help investors take a deep dive into their asset allocation to make sure their portfolio is still mapped to their goals, risk tolerance, and time horizon.

To be sure, investment losses are painful, but if investors can stay focused on their individual goals—rather than fixating on daily market noise—they will likely feel better and be better off in the long run.

The source of this Morgan Stanley article, Top 5 Mistakes Investors Make in a Market Sell-Off, was originally published on March 14, 2022.

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