What to do when the stock markets decline sharply?

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What to do when the stock markets decline sharply?

By Claus W. Silfverberg, director, WFIC

According to one theory you should stay calm and do nothing. The stock market will eventually climb to new heights. And it is impossible for you to time your investments – the short term development of the stock market is unpredictable, most of the time the market is flat and stable, and positive and negative price developments occur so fast you are not able to react.

According to a second theory you should rebalance your portfolio and buy more stocks. Rebalancing is necessary because you have an investment strategy or an asset allocation, which you believe is just right for you. When the stock market decline the relative value of your stocks diminish and you need to buy more stocks to re-establish the right proportions.

According to a third theory – advanced by a.o. Warren Buffett - you should “be greedy when everybody else is fearful” – i.e. you should buy more stocks. When stock markets decline, investors tend to overreact, and stocks fall to prices well below their long term value.

According to a fourth theory you should have stop losses on all your shares and sell immediately when the price drops below the indicated level. Since this theory mainly applies to individual stocks and not stock markets in general, perhaps we may neglect it when considering declines on the stock market.

According to a fifths theory you should never buy stocks as long as they are falling in prices, but wait until the price fall has stopped. Then you should be an active investor.

According to a sixth theory you should sell your stocks when the short term moving average price falls below the long term moving average price, and only start buying again when the opposite occurs.


What do private investors actually do when the stock market decline?

Most of us stop trading. Most of us act according to the new trend of the stock market with a 6 months delay – both when the stock market collapse, and when a new bull market begins. Most of us overreact based on our short term experience – at one time we are too optimistic, and at another time we are too pessimistic. Some of us loose a terrible lot of money because we have committed a number of sins – we have too few stocks in our portfolio, have stocks in poor quality companies, have illiquid stocks, or have been investing based on borrowed money or money we need for daily consumption.

Conclusion

It is difficult to tell which of the theories is the right one, but looking at our normal behaviour it seems clear to me that we need to invest in a more rational manner – do our homework before choosing the companies in which we invest, base our investment on long term perspectives, base our investment on fundamentals such as p/e figures over a long period of time, base our investments on demographics and macroeconomics, learn about the stock market fundamentals, and last but not least base our investments on our individual investment profile and strategy, and not on whether the stock market goes up or down.