3 things you shouldn’t do if the stock market crashes

There is a good and a bad way to deal with stock market crashes. Getting it wrong on the following could permanently reduce your returns on your investment. Avoid these three common mistakes if you want to navigate the market cycle like a pro.

1. You shouldn’t panic

It is almost impossible to remove emotion from your financial plan. Who could be completely impartial when it comes to their children’s college funds or their retirement nest egg? You’ve spent years saving and investing diligently for growth, of course you’re going to panic a bit if your assets suddenly rise in value.

However, you have to resist the panic instinct if you want the best long-term investment results. It’s easier said than done, but consider historical market dynamics for a valuable perspective. Volatility is a natural part of investing in stocks, and stock market crashes do happen. If you are in the market for the long haul, bear markets are inevitable. Don’t blame yourself or your advisor when something happens that we should recognize as inevitable.

Image source: Getty Images

Accepting serious periodic losses may seem bleak, but there’s a good reason for it: The slowdowns are temporary. During each 15-year period, starting on any day in its history, the returns for the S&P 500 were positive. Capital flows in and out of the stock market, but economic growth ultimately increases the value of companies.

Recognize this fact in advance and build your financial plan with this knowledge. When the market is down, remember it and expect new opportunities on the horizon.

2. You shouldn’t sell your stocks

This one is much easier once you master the ‘don’t panic’ approach. Selling your stocks in the middle of a stock market crash might be the worst thing you can do. This is the exact opposite of the buy low, sell high cliché.

You can check the value of your portfolio on any day, but these gains are not realized until the positions are closed. Open positions are like chips still on the table in a casino – you’re not really a winner until you withdraw and leave the building. Obviously, it feels good when your accounts are up, but you have to sell your stocks for money in order to buy something else.

Selling your stocks at the bottom of the market blocks your losses. Worse, if you get rid of your stocks and don’t buy them back, you’ll miss out on some of the growth when the market inevitably rallies.

The key is to understand your time horizon and your personal risk tolerance. If you are still 20 to 30 years away from retirement, the exact balance in your IRA or 401 (k) today is not entirely relevant. You will go through a few more market cycles before you start making withdrawals. Since you have time to wait for another market rally, you should prioritize long-term growth.

On the other hand, you should not expose your investments to volatility if you need to liquidate them quickly. Retirees, for example, might need to sell their stocks for cash in the next few years. They should build a more balanced portfolio of assets to supplement social security income. Adding bonds or cash will reduce volatility and limit losses. Don’t put yourself in a position where you have to sell during a crash. Plus, you’ll have extra cash to buy stocks at lower valuations.

3. You shouldn’t be afraid of growth stocks

This takes the “don’t sell” approach a step further. Stock market crashes are in fact the better focus even more on growth, but some spooky stock charts are likely to cause some concern.

Growth stocks take a hard hit during bear markets, so they’re likely to perform much worse compared to value stocks and the market in general. History can be a valuable guide, but returns on investment depend on future results. The stocks that fall hardest in stock market crashes tend to be the ones that perform best in subsequent bull markets.

It becomes clear when we look at the Vanguard Growth ETF‘s (NYSEMKT: VUG) performance compared to Vanguard Value ETF (NYSEMKT: VTV) during the last two major collapse-recovery cycles.

VUG chart

VUG chart

Data by YCharts.

The merits of each stock play an important role in returns, but the trend applies, all other things being equal. This does not mean that you should radically change the allocation of your portfolio. Overall, you need to establish a target allocation based on your personal goals and tolerance for risk. However, changes in valuation change the risk / reward profile of stocks over time. When the market collapses, growth stocks look more favorable, and it is not a bad idea to modestly move your portfolio towards the most aggressive allocation that is acceptable in your personal risk profile.

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Ryan Downie has no position in the stocks mentioned. The Motley Fool owns and recommends the Vanguard Growth ETF and the Vanguard Value ETF. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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