In bear markets investors make more mistakes than they would normally make. In the short term, stock prices are volatile and in bear markets they can be extremely volatile. In a simplified explanation: when many sell orders are placed and there are not many buy orders, the stock price will fall (supply and demand). Thus, in a declining bear market, a fall in stock price is often the result of too many sell orders being placed. What would cause so many extra sell orders? Personal investors selling out of fear to cut losses, and fund managers selling off their positions to close out investors that have chosen to sell their mutual funds (out of fear).
1) Making Emotional Decisions
Financial decisions should never be made emotionally. Logically, financial decisions should only be made using logic. But I agree, it’s easier said than done.
When financial decisions are made quickly and without adequate research they are not likely to be good decisions. Money management decisions should be made after doing adequate research and should align to your financial plan.
If you are the type of investor that consistently makes quick financial decisions based on emotion, I suggest forcing yourself to plan all of your financial moves in advance with a predetermined amount of time. For example, you plan on investing some cash assets and are looking for some stocks (or mutual funds, CDs, anything). To prevent making an emotional decision, do not allow yourself to make the investment until 2 weeks after you have done all of your research and made your decision. This will do 2 things for you: 1) Force you to do research (because you are probably very anxious to put your money into an investment), and 2) Prevent the excitement of emotional trading to lead you into a bad investment. Granted you might miss a good purchase opportunity of the stock jumps in value before you buy. But chances are it won’t change in value much over the 2 weeks, and halfway through your waiting period you might realize the stock was a bad choice in the first place.
Likewise, why would you sell assets without doing adequate research to see if there is even a better option for your money after you sell? The key to investing is having a long term plan, and sticking with it. Fast, irrational, emotional decisions will not lead to long term growth.
2) Selling at the Bottom
Large portfolio declines in a bear market can be frightening, but reacting to market falls with fear is very detrimental to long term growth. Remember “Buy Low, Sell High”? If your investing goal is capital gains then this simple adage still applies.
Selling after large declines in value solidifies your losses without giving the investment a chance to recover. If you initially did your research and you still believe in the fundamentals of the company, then the investment should recover. In fact, you could even use the opportunity to buy more of the investment at reduced values. If you do not think it will recover, you probably should have never made the initial investment. Selling investments before you planned to also creates income tax implications.
The only logical reason for selling off investments after large declines would be if the money is needed in the short term (next 4 years) for retirement or other expenses. Ideally, money needed for retirement in the short term would be invested in lower risk investments that would not decline so sharply close to retirement.
3) Reducing Risk at the Wrong Time
After large market declines, some people reorganize their investments and 401k account allocations looking for reduced risk. While reorganizing your investments (and staying in the market) is better than selling to get out of the market, it is not always the best option. Lower risk funds generally see lower returns over time while higher risk funds see higher returns. Your portfolio should be tailored to your financial plan with the appropriate amount of risk. The amount of risk you are willing to handle should not change based on your fear of the market (remember point #1?).
In fact, going from high or medium level risk funds to a low risk fund at market bottom will reduce your earnings when the market turns around. When the market recovers you will be positioned in very conservative low risk investments that will not grow with the market. Staying with your current investment plan or even adding higher risk growth investments (such as growth funds, index funds, or growth stocks) will give you the opportunity to be positioned properly to make higher gains when the market rebounds.