How to Ride Out the Market’s Slide

This week’s snowstorm across much of the eastern half of the country has been accompanied by the usual clips of cars sliding backwards down icy roads. Those are sickening sights, but not as sickening as watching global stock markets sliding backwards, pushed by China’s slowing economy and plummeting commodity prices. No matter how hard the world’s central bankers gun the engine, the tires keep spinning and the car continues losing ground.

So we watch helplessly as more wealth is siphoned from the global economy, wondering how much longer until the stock market gains traction. Of course, no one knows exactly how much longer this will continue. The optimist in us would like to believe that this correction has already gone too far, and will soon reverse. But the pessimist in us suspects we could end up considerably lower.

This is the classic dilemma investors face every time the stock market drops precipitously. If your portfolio is deep in the market, you wonder how long to hang in before bailing; and if you’re sitting on a lot of cash, you ask at what point should you jump in and buy stocks while they are so cheap?

Regardless of which camp you occupy, here are a couple of things to remember as you evaluate your options. First, as the old saying goes, “no one rings a bell when the stock market hits a bottom.” It usually isn’t until many months have passed that we realize the worst is finally behind us. By then, much of the opportunity has been lost. Some investors then wait for a second dip, which may never come.

Second, a “dead cat bounce,” Wall Street’s morbid expression for a quick, temporary rebound after a big drop, can look a lot like a full-blown recovery. Those who buy on the bounce may just be compounding their losses. Getting “catnipped” liked this is not only painful to your portfolio, it’s embarrassingly in hindsight.

For those reasons, most experienced investors choose one of two paths to follow when a correction occurs: ride it out regardless of how low or how long it goes on, or sell out after the decline exceeds some threshold and then wait until it is absolutely clear the worst is over before reentering the market. Either method will work okay from a long term perspective, since the mathematical outcome for both is about the same, on average.

What doesn’t work is attempting to combine the two by jumping from one approach to the other since our emotions almost always get the better of us in the short run. It is human nature to extrapolate the current condition indefinitely into the future, thereby becoming overly pessimistic. Human nature also makes us unrealistically optimistic when the trend is positive. For that reason, unseasoned investors tend to buy high and sell low repeatedly.

At Personal Finance, we advocate a more sophisticated approach to managing your portfolio through market cycles. We adjust our asset allocation model periodically to reflect the overall level of risk in the market, which we currently have set at 50% for stocks. As we see increasing evidence of less risk of global deflation we will adjust that percentage upward, but until then we are not comfortable being more fully invested.

For the money we do have invested in the stock market, we use our IDEAL rating system to avoid companies that appear to be grossly overvalued, and limit our portfolio holdings to those that are more reasonably priced. The combined effect of our asset allocation model and stock rating system is having limited exposure to stocks during times of above average risk, and limiting our portfolio holdings to stocks that have, as a group, less downside risk to begin with.

No one method is perfect, but it doesn’t need to be. In fact, some of the most successful investors– Peter Lynch and Warren Buffett among them – admit to viewing these types of market pullbacks as necessary to propelling their portfolio values higher. They shop for bargains when the market is down, skillfully managing through a correction, not avoiding it altogether.