Investing in a Down Market

by Michael on Feb 14, 2013

Graph of a Stock Market Crash

The ever-excellent Mike Piper of Oblivious Investor fame recently tackled the question of what to do when the stock market crashes.

This is a very important question, and one that most investors will grapple with multiple times throughout their investing life.

In his article, Mike outlined three possible reactions, including: (1) rebalance, (2) do nothing, and (3) pull your money out of the market entirely. I just wanted to share a few thoughts about each.

For starters, depending on the extent of the crash and what it does to your asset allocation, a strong argument could be made for #2 — do nothing at all. Instead of reacting, just ride it out and wait for the market to recover.

If you opt for #1, make sure that you have rules in place for when to rebalance. The last thing you want to do is to continually exchange into a market that is melting down. It’s far better to rely on set time points or (preferably) rebalancing bands.

For example, with a 60/40 allocation of stocks/bonds, you might say that you’ll rebalance once you get outside the range 65/35 to 55/45. Until that happens, you just sit tight and let things ride.

As for option #3, if you’re tempted to abandon the market entirely, that’s probably a sign that your allocation wasn’t right in the first place. In this case, you need to seriously re-consider your risk tolerance before making any moves.

For the record, there’s actually a fourth option out there: overbalancing. That is, taking an out-sized (relative to your base allocation) position in a beaten down asset class. In other words, be greedy when others are fearful.

I’ve never been one to adjust my allocation in response to market performance, but I know that others have done this with mixed results. The risk, of course, is that you’ll overbalance into a collapsing market, thereby amplifying your losses.

Sure, once the market rebounds, you could still come out ahead. But remember… You’re changing to a riskier allocation so you’re comparing apples and oranges.


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