Strategy When Stock Market Starts Falling | Investor Junkie

With the Dow Jones Industrial Average hitting an all-time high in the past three years, this doesn’t seem like the right time to contemplate what you would do in the event that stocks should start to fall.

Or is it?

The market tends to get nosebleeds when it sets new records.

New highs — logically of course — represent the beginning of bear market cycles. But it’s an open question as to how high is too high, or at least high enough to trip of a round of selling on a major level.

The Dow Is Back! What’s the Best Investment Strategy?

The optimist might ask, “what’s the big deal, 15,000 is just a number?” That’s true enough. So were 10,000, 11,000, 12,000 and so on, and the Dow Jones Industrial broke through them all.

But as the Dow goes, this is a very big number, and that has an important psychological effect. The investment community is comprised of millions of people, and people all have human emotions that often guide them in their decisions.

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When we look at small numbers, they look manageable so we’re more comfortable with them, but when we look at large numbers we get a little scared.

It doesn’t matter if there’s no substance to the fear of larger numbers — perception alone is what causes people to act. If enough people get spooked by a big number, a sell-off will follow, facts be damned. So it was with the last three major market downturns.

The 1987 crash happened just a few months after the Dow topped 2,700. Did the fear of a 3,000 market have anything to do with that?

The 2000 slide began after the market topped 11,700. Was 12,000 looking like too much to handle? In 2007 the decline began after the market broke past the 14,000 mark, then dropped the Dow by more than 50%. Did investors decide that 14,000 overshot the mark?

I’m not trying to imply that the Dow crossing the this mark for the second time means that a downturn is automatic. But there is solid evidence that new highs increase the risk.

Now that the Dow is back in record territory, where do you think it’ll go from here — and more importantly, how do you expect to react?

Buy When Everyone Else is Selling

The standard investing advice on Wall Street has always been to buy when everyone else is selling. Is this a strategy that you plan to follow?

If you do, at what point do you start buying and how aggressively?

One of the problems with this strategy is that you could buy-in after the market has fallen. So what happens if, over the next year the market falls another 30% from that level? You may not take as big of a hit as people who bought in at of the top, but you’ll be taking a large hit nonetheless.

The previous two market slides have shown that a drop of 50% or more is hardly out of the question.

Sell and Limit Your Risks

Another option is to start selling, so you free up your cash and can buy stocks later at bargain prices. This is an excellent strategy, but there is one serious flaw. At what point do you push the panic button and begin selling again?

Trying to sell into a declining market can be something like chasing a greased pig. A 10% or 20% decline in the market is hardly uncommon.

If you sell after the market has sold off, there is a huge risk that the market will turn up, locking in your losses and preventing you from participating in the recovery.

The basic limitation is that you can never know if a drop is a routine correction or the beginning of a protracted decline.

Hold and Stick to Your Game Plan

If a market decline turns out to be a correction — as most are — it’ll be easy enough to just ride it out until the market resumes it’s climb.

But during more serious declines, like the 1973-74, 1987, 2000-02, and 2007-09 markets, the ride down can be serious white-knuckle time. Those are the kind of markets that test even the most committed investor’s resolve.

Even though in each case the investors who held on well past the crashes were handsomely rewarded for their perseverance, it’s often difficult to accept that concept after stocks have fallen significantly and are continuing to do so. It can take nerves of steel, and not everyone has that.

What’s your plan if the market starts to fall? Will you buy, sell or hold?