4 Painful Mistakes You Should Avoid Making in a Market Downturn

IMPORTANT: Please read the disclaimer before continuing.

We are facing a whole range of economic issues coming at us all at once – from oil prices, low consumer sentiment, higher interest rates, and a resurgence of covid-19 cases in China.

A healthy growing world economy, coupled with a reasonable inflation rate of between two to four percent, is advantageous for the stock market. We’re getting none of that right now. Instead, we are running into a possibility of a recession or stagflation.

When this happens, the Federal Reserve may have limited tools to navigate the situation as its current interest rate is already very low. Dropping interest rates may not stimulate the economy any further. Also, inflation is created by supply chain issues that cannot be resolved overnight. It’s further exacerbated by rising oil prices caused by geopolitical tensions. 

The stock market across the world is down. It’s the same for many companies in my portfolio. For some of us, we would rather not look at our portfolio, forget about the stock market, and carry on with our lives. 

Our defence mechanism tells us to escape from the pain caused by paper losses.

But this is not the time to retreat. This is the time to be crystal clear about your portfolio. 

Good investors are both comfortable seeing their gains and losses in their portfolios. 

It’s like driving – you don’t only want to know that your car is moving, you also want to know which direction it is headed towards. Knowing how your portfolio is reacting to the stock market puts you back in the driver’s seat so that you can have control and clarity on your portfolio. 

“Do I add more stocks since the price is attractive relative to the company’s intrinsic value?”

“Do I re-allocate some positions to higher certainty higher conviction stocks?”

It’s better than thinking, “I know the stock market is falling and I prefer not to look at my brokerage account.”

With the stock market deteriorating further, we must bulletproof our portfolio by asking these questions about our companies:  

1) Are their products/services recession-proof or mission-critical?  

2) Do they have a strong balance sheet to weather through tough times? If not, they need to raise capital at a time where interest rates are high.  

3) Do they have healthy profit margins? Otherwise, their profit margins may shrink as labour costs go up. 

4) Are they still able to grow in our current economic climate? 

How to Prevent Behavioural Pitfalls 

There is a saying:

“It’s what you do when you’re in trouble, not when you’re okay, that makes you successful.” 

A part of surviving any period of difficulty is doing a check on our behaviours. We humans tend to do illogical things when there is undue pressure.

If you are a stock investor, you will be feeling a lot of emotions now. Since the majority of us are sitting on some paper losses, there are temptations to do something to ease the pain.

However, you should avoid these common pitfalls if you want to be successful in the stock market:

1. Taking on margin

Some investors may borrow money to further invest in the stock market. I’ve heard of cases where some investors did that and the market tanked further, amplifying their losses. They lost sleep and appetite. No one knows when the market is going to bottom. Lower can go lower. By borrowing money, an investor is squeezing himself/herself even further.

2. Selling stocks due to emotional reasons

When losses continue to pile up, it becomes unbearable for some investors. Despite understanding fundamentals and valuations, they may sell simply because they want to ease the pain they are facing. It’s psychologically challenging. The human mind is wired towards a mentality of flight to safety. Some would rather rip off the band-aid and realize their losses, than live through the “pain” of having a red account. But when the stock market recovers, they don’t get to enjoy the recovery either.

When stocks are so cheap, it is better to buy them instead of selling them. It’s difficult to practice this as it seems to go against our instincts. It’s almost like telling you to run into a house with fire instead of running out of it. But that’s exactly what you need to do.

3. Having unrealistic expectations

Year 2020 was an exceptional year where many investors made a tremendous amount of money. Many stocks literally flew up. Most investors are expecting such returns to continue in 2021, 2022 and beyond. It’s not going to happen. The markets will deliver higher returns in some years, and lower returns in others. On average, the markets will deliver satisfactory returns. Having unrealistic expectations might lead to frustration, leading investors to take on riskier positions such as options and margins to generate more returns. It can backfire very quickly if the market continues to tank, escalating your losses. 

4. Having a short term investment horizon

Trees don’t grow overnight, and neither do companies. Some investors expect to make money from the day they buy a stock. The stock market is not a good feedback loop. There are times when the good companies you buy do not get recognised by the stock market. Its share price may even dip from your purchased price despite reporting higher sales and profits. When investors give themselves such a tight deadline to succeed, they are setting themselves up for a huge disappointment. We need to have a long horizon for our investments to work out well. 

Famous investor Peter Lynch shared:

In my investing career, the best gains usually have come in the third or fourth year, not in the third or fourth week or the third or fourth month.

In my Growth Investing Mastery investment class, I shared this slide:

Despite growing revenues, shareholders of Tesla had to endure two years of near-zero returns before they saw the spectacular returns that happened in 2020. Warren Buffett shared: “The stock market is a device for transferring money from the impatient to the patient”. Having a short term mindset is disastrous because it might cause you to sell your stocks away before they start to work out. 

When everyone is losing their minds during this period, you just need to avoid behavioural pitfalls and you will naturally be in a good position. 

I also tried to find out why some investors are feeling so zen during this period. 

These are my findings: 

They have invested money that they do not need for the next few years, as as well placed aside a sum of emergency funds. On top of that, they have done their proper due diligence and understood the valuations before buying into the companies.

On the contrary, if one invested money that is needed in the next 12 months (eg: for housing, renovation, education fund) and did not do any due diligence, it is natural to feel anxious. Anxiety hinders us from thinking clearly. 

Generally, most people have good intentions when they invest. They want to provide a better future for themselves and their loved ones. It’s when they get impatient and want to quicken the process that they take on unnecessary risks, landing them into problematic situations. Some could be catastrophic, resulting in them losing their hard-earned money. 

In short, all of us will eventually become rich when we stick to our framework and process by investing in money that we can leave there for 3 years. The stock market is filled with ups and downs. You need to be able to ride through the volatility without being hurt. 

Closing

As I speak to many different investors, it’s crazy how we define our self-worth based on our portfolio value. We are emotionally attached to our wealth. Given the huge drawdowns in many companies, most investors are painting a very bleak picture of their own future. They see their hard-earned money vanishing into thin air. 

Well, we can choose to see our situation as half full or half empty. 

If we are buying Super Stocks that are growing their revenues well, then what we are facing now is a temporary drawdown caused by price multiples compression. The intrinsic values of those companies are still growing. Take this opportunity to dollar cost average slowly for the best companies you can find and invest with a multiple-year horizon. 

It’s hard, but it is the best thing to do now. Trying to time the market by selling stocks now and hoping to buy back later is not a wise strategy. Should a surprise rally occur, you would lose out entirely.

The world will often find a way to correct itself back to a path of growth. Politicians need a strong economy and a strong stock market to win votes. Who knows, stocks may recover in the next few months and you will thank yourself for buying them at cheap prices today.  

Also, the truth is that if you’re hanging out with the right people, they will like you for who you are – not for your wealth.