How do you respond when things look a little crazy on the stock market? Should you sell your stocks and go to cash during volatile markets, or should you stay the course, and keep your money invested for the long haul?
One of the most common responses is to get worried and sell, deciding to go to cash. According to T. Rowe Price, that can be costly in the long run. While it might be hard to hang in there when you see your portfolio drop in value, for many long-term investors, it’s best to turn off your emotions and stick with your investing strategy.
Deciding to Go To Cash When Markets Drop Can Cost You
The biggest problem with selling when you get worried is the fact that you are essentially “locking in” your losses. Until you actually liquidate your stocks, your losses are pretty much just on paper. They don’t become “real” until you sell. Essentially, when you sell during a market downturn, you are selling low after you have bought at a higher price.
You will also see other costs when you go to cash during a downturn. Not only do you lock in current losses, but you also run the risk of losing out on bigger future gains.
I use a dollar-cost averaging strategy with my long-term investing. I invest the same amount of money each month, no matter what’s happening with the market. This means that when the market is lower, I essentially end up buying my investments “on sale.” During a market recovery, that means that my portfolio grows at a faster rate than someone who has been growing a cash account, and finally decides to get back in after prices have begun rising again.
The T. Rowe Price article includes an illustration of two investors who set aside $2,000 each quarter from the beginning of 2001 through the end of 2015. One investor sells and goes to cash when the market drops by 10% or more in a quarter, and then doesn’t get back in until there are four quarters in a row of positive returns. The other investor just plugs away, putting that money into stocks, no matter what is going on. By the end of the exercise, the investor that goes to cash has less than half the account balance as the investor that was able to take advantage of low prices and bigger returns.
This illustrates how deciding to go to cash can cause problems, especially if you do so after the big market drop. While some of this can be mitigated if you sell and switch to cash before a market drop, the reality is that few of us are good at timing the market in this way.
Using Asset Allocation to Improve Your Peace of Mind
This doesn’t mean that there is no place for cash in your investment portfolio. The danger comes in making big changes to your portfolio during times of market turmoil. Instead, it can make sense to use asset allocation to your advantage over the long haul.
You can create a portfolio that includes cash and bonds (and maybe other assets, depending on your goals and risk profile) in addition to stocks. It might help you sleep better at night knowing that you portfolio is 70% stocks, 20% bonds, and 10% cash. In some cases, you might even tweak those numbers, depending on where you stand with your financial goals and risk tolerance.
The idea is that you can consistently invest in those set proportions, occasionally rebalancing as you see drift in your asset allocation. With this method, you can use index funds or ETFs to help you manage your investments, rather than worrying about stock picking. It’s one way to reduce some of the risk and increase the chances that you will come out ahead in the long run.
Carefully consider your situation and what makes sense for you. However, be aware that most ordinary investors don’t do well with stock picking. Also keep in mind that, often, the very worst time to sell your stocks and go to cash is when everyone else is panicking and doing the same thing.