With the S&P 500 down 10% from closing highs and the Nasdaq erasing all of this year’s gains, we are now well into correction territory. A correction is a 10% decline from recent highs.
Actually, if you bought FANG+ stocks, you are now in bear territory. The NYSE FANG+ Index closed down at 2377, which marks a 22% decline from its all-time time high of 3045.95 reached on June 20. Facebook, Alphabet, Amazon, and Netflix have each lost more than 20% each in market valuation.
We know that the stock market can take a dive. It is well-documented and people even make movies about it. Yet, we tend to forget that it can happen to anyone, especially after a winning streak.
When there is a sudden correction, experience is the best tool to cope with the surge of volatility and sense of panic that tends to come with those situations. If you do not have that experience, here are some tips to help you out.
A quick guide on how to avoid stupid mistakes during a sudden correction
1. Stay calm and carry on
Do not frantically log in your online account and start selling everything.
Unless you bought bitcoins, and then you might want to sell all of them. Even then, it is not a given. Personally, I believe that a cryptocurrency will emerge as the king of cryptocurrencies. It won’t be bitcoin, that’s for sure. But that currency is out there.
It is important to remember that your financial safety net is still active. Of the five steps, only two would potentially involve stocks.
The first one is your pension pot that probably involves a combination of stocks and bonds. This pot is off-limits. You had no intention of selling when the stock market was beating records so there is no reason to sell now that it is taking a nose-dive.
This rule holds true for everyone who is below 50. Even if you are over 55 years old, the managers running the pension fund may have dialed back your equity exposure to minimize losses as you near retirement. Most people now retire around 62 in Europe so you still have 7 years to catch the rebound. There truly is no need to worry. 7 years was enough to recover from the 2008 financial crises, which was the worst financial meltdown since the Great Depression.
Transferring your pension pot at the last minute to take a shady advisor and then take out lump sums will be more harmful than selling during a correction.
The second step that may involve an equity component is the ISA account. This assumes that you opened a stocks and shares ISA. If you opened a cash account, which is the easiest version to start with, then you have no exposure to the stock market. With a stocks and shares ISA, you could potentially rebalance the portfolio but I would not recommend it. Wait a couple of weeks or months for the dust to settle, and then rebalance based on your new markets outlook.
The main point is that your financial safety net is intact. If you fall sick, you still have medical insurance. If you paid off your debt, then nobody is coming after you. Not all is lost.
2. Reassess your objectives
You now know that the correction will not lead to your financial ruin. However, the financial safety net is more about survival than living and enjoying your life. Money is meant to be used as it should serve you. Not the other way around.
As someone turning 30 next year, I have had the following financial objectives:
- Save enough to put down 20% plus all costs for a £1,000,000 house in London;
- Save enough to pay for a $50,000 plus engagement ring;
- Save cash aside to pay for a wedding;
- Maximize my pension contributions, which are capped at £10,000 per year because of the tapered annual allowance;
- Fully use my ISA allowance as I hold a cash ISA that will be used for the house downpayment.
I do realize that those objectives might be very ambitious. That’s because they are. Besides the amount spent on the engagement ring, the sad reality is that the other objectives are pretty standard:
- £1,000,0000 for a house in London zone 1 will not even get you a three-bedroom. I favor a central location because that’s where the work opportunities are and commuting in the UK is incredibly expensive.
- Save for a wedding is fairly self-explanatory. It does not have to be anything grandiose but you still have to pay for the venue and catering at a minimum.
- Pension contributions are of course non-negotiable. The tax incentives are too important: even if your pension contribution goes towards a stock that suffers a 10% correction, you are still making money due to the tax relief granted by the government. This remains true for basic rate taxpayers and is especially true for high-earners.
- Saving in a cash ISA account really is meant to fulfill the other objectives. This should be considered in conjunction with my other targets.
Notice how cash intensive those objectives tend to be. As a result, I have a very little invested in the stock market. It might feel good right now when markets plummet and struggle to recover but this is not the way I feel. I actually wish that I had more money invested in the stock market. I missed out on a great bull market over the last few years. To be fair, I was busy paying back debt and establishing my career. Still, it might take some time for a similar opportunity to pop up.
Over time, I intend to buy as many dips as possible to build up a sizeable stock market position. I intend to start in earnest once I have bought a place in London. That rent is really is a waste of money.
3. Determine your appropriate risk tolerance level
If you have properly determined your objectives, you have a rough idea of what available cash you have to invest in the stock market.
When you invest, you will have hopefully assessed your risk profile, which includes your risk tolerance. I don’t invest much but when I do, I take insane risks. This is why I have a YOLO account. For larger amounts, I take a more conservative approach.
If you invest larger amounts, it is worth remembering the following:
- The amounts invested in the stock market should not be earmarked for other purposes. Obviously, mortgage payments should not be invested in the hope of making some quick cash. The same goes for your wedding fund unless you are ready to find a new partner…
- Ensure you have enough cash within your brokerage account to buy the dip. Stock markets are like rollercoasters but you should not be powerless and strapped in your seat forced to endure the ride. Give yourself some leeway to buy the dips if you invested too much too quickly.
- The allocation of your portfolio should be continually reviewed. Take a view on the market, readjust your positions and then stick to it for at least a few weeks. Anything sooner than a few weeks is almost like day trading in this environment.
People tend to over-estimate their tolerance to risk. It is only when you start losing thousands of pounds in a month that your tolerance to losses is put to a test. As a rule of thumb, reduce by 10% to 15% the risk tolerance that you determined was appropriate for yourself. Another way to think about this is to increase by 10% to 15% the amount of cash that you had originally decided to set aside to buy dips.
Your risk tolerance may end up being different depending on personal circumstances. If you are single without kids, you probably have a higher tolerance to risk than someone with a mortgage nearing retirement. Continually review your risk exposure to make sure that you are comfortable with it.
A good rule of thumb to determine your tolerance to risk relates to how long would you last without checking your positions in your portfolio. If you can have your portfolio on auto-pilot for more than a month, then you are either (i) uncomfortable with the amount of money you invested and (ii) invested in financial instruments that are extremely volatile because they require constant monitoring (like short-term options).
If you are losing sleep at night over your risk exposure, then you did not assess your risk profile properly. The stress and anxiety will prove to be significantly more costly over time. Address this issue as soon as possible!
4. Continue to save and maintain strong cashflow levels
Mistakes and bad investments happen. All great investors have had at least one deal where things turned sour. Warren Buffet’s investments in Tesco is a good example. That investment cost him $444 million!
What matters is less the loss itself but how long do you need to get back on your feet. If I lose a £1 million this week, most people will tell me my life is over.
However, if Iknow that I can generate £4 million within the next three months, things are not as bad as they look like. Losing 25% is not great but this is not 25% of my net worth. This is only 25% of the cash-flow that I generate on a quarterly basis.
Let’s take a more realistic example: you saved £1,000 this month. You lost £250. Two observations must be made: you still have £750 readily available to buy the dip if you choose too. Second, and more importantly, you know that you have another £1,000 coming in next month.
Cashflow generation is always more important than net worth. You might have a high net worth because you purchased lots of properties. However, if you do not have sufficient income to pay taxes and maintain those properties, they will lose in value and you may be forced to sell. The net worth will, therefore, diminish due to weak cash flow. If you are interested in reading more about this topic, check out this great article from Sam at Financial Samurai: How A Big Expensive House Can Ruin Your Life and Path to Financial Freedom.
A strong saving rate will allow you to buy the dip. Even taking modest action will boost your confidence and self-esteem because you will have the impression that you are doing something to mitigate losses. Without a strong cash flow, you are stuck on that roller-coaster.
5. Get a side hustle
If you noticed that your ability to generate a strong cash flow was weakened due to a poor investment, then it is time to remedy this. Do not take comfort in thinking that bad investments happen to everyone and that less income may be normal as a result, even on a temporary basis. If you think this, you are not giving yourself a chance to reach financial independence. You are just postponing the hard decisions.
Get a real side hustle to improve your income level and, preferably, do something that you own and control. Riding for Deliveroo or driving for Uber are only short-term emergency measures for situations where you gambled your rent on the stock market. You should not have to resort to such desperate measures.
Not all side hustles are equal. Some are just second jobs. They might not be very inspiring but at least you get some form of medical insurance and maybe even pension contributions from your employer. Others are worse: you are essentially working for some big tech company in Silicon Valley with no fixed salary based on the demand there is for a given day.
Finally, there are side hustles for which you start a small project. Starting a blog, selling niche products in small quantities on eBay or incorporating yourself as a tutoring business. Those are the side-hustles that require you to build some capital. It does not matter how small it is at the beginning. With those side-hustles, you have a chance, a possibility to generate semi-passive income. It might not be much in the first few months. But it can only pick up from there.
Focus on building capital to generate further income in the long run. This is what you meant to do with that poor investment that weakened your cash flow. It is now time to start again.
6. Enjoy your life and try new things (i.e. do not check your balance every 10 minutes)
It’s not healthy to check the balance of your Interactive Brokers account every 10 minutes. In a correction, all you will see is the color red. And also larger numbers in red. Lots of red, you get it.
Life is short. I’m barely 30 years old and I’ve already realized that. Hang out with your partner, exercise, call your mom, buy a beer to a friend, and enjoy playing guitar or try something new. The possibilities are endless. These are the moments to remember in a few decades.
It sounds cliche. Above a certain income level, the marginal benefit of additional income becomes very small. You might not be able to buy a penthouse in Mayfair. But you are not lacking anything, you can travel whenever you want to and you have a reasonably stable situation. More money is not going to change much. The thrill of starting something to make more money is a different story…
Checking how much money you are losing will only bring more anxiety, more stress and the worst is that there is nothing you can do about it. It’s just not a rational attitude.
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