Thanks in part to high inflation and the risk of stagflation, it has been difficult to invest in stocks so far this year. Still, most tough markets carry with them the seeds for the next recovery, and this one likely will as well.
The challenge, however, is that by the time investors recognize that they are firmly in the midst of the next recovery, much of the early and outsized returns may have already been realized. Therefore, it is important to be willing and able to stay invested even when the market is crashing. This is easier said than done, but there are four steps you can take to help prepare yourself and your portfolio to enable you to stay invested even in a tough market.
1. Have a long-term perspective
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It is better to invest in stocks if you have a long-term time horizon. As Benjamin Graham, the guy who taught Warren Buffett how to invest, once said: “In the short term, the market is a voting machine, but in the long term it is a weighing machine.” In other words, while the market can move wildly up or down on any given day, in the long run, a stock’s performance is ultimately tied to the performance and outlook of the underlying business.
In that framework, it’s important to recognize that while the market should ultimately reflect the true value of an underlying company, it can take a long time to get there. As a result, you need enough patience to wait out that long term and enough objective perspective to be able to estimate what that fair value looks like.
2. Make sure your own financial house is in order
It’s much easier to have the patience to wait long-term if your finances can handle the wait. For example, if you expect to need your money within the next five years, it doesn’t belong in stocks. The reason is simple: if you have to liquidate your shares to cover a short-term expense, that money simply can’t wait for a market recovery.
Beyond that cold hard truth, even if I might delaying an expense due to a choppy market, if you see a risk to your lifestyle fueled by a falling stock market, it’s likely to affect your mindset. It’s easy to fall into the trap of thinking you have to sell before things go from bad to worse, when in fact, stocks might be getting cheap enough to buy them hand over fist.
3. Have a good estimate of the value of the stock you’re considering
To recognize when a stock is getting cheaper, you must first be able to monitor the real value of the company behind that stock. A tool like the discounted cash flow model can help you calculate that intrinsic value.
To use it, you essentially start by estimating how much money your business will make in the future. So you look when you’ll earn that money and re-mark it (or “discount”) it based on how far into the future you’ll earn the money and how risky those projections are. Finally, you add up all those discounted future earnings, and the result is your best estimate of what the company is worth.
The advantage of that approach is that it can give you a fundamentals- and operations-based way to understand the value of a business. The downside to this is that your guess is at least as good as mine as to what the future actually holds for the business. By the time the future unfolds, much of the real benefits will have already been made or lost depending on what actually happens. In reality, no one does it perfect 100% of the time.
4. Recognize the risks of being wrong and diversify appropriately
Because no one gets it right all the time, it’s important to manage your investments with at least an eye toward diversification. Done right, diversification can minimize the impact on your overall portfolio if any one of your investments fails. That way, even if you mess up from time to time, you can generally end up well as the long-term returns of your hits can outweigh the losses of your misses.
The key to wise diversification, however, is making sure that each investment you buy is one you’re willing to own on its own merits, and not just a choice to satisfy a diversification need. That way, even as you spread your risks across multiple industries, every investment you make has a legitimate chance to generate the returns you need.
Put it all together and you have a plan that is easier to follow
These four steps make navigating a tough market a lot easier and improve your chances of making the right decisions for your long-term financial health. They won’t stop you from seeing your portfolio drop when the market is rough, but they can help keep your head on track during the downturn. That can help you make smart decisions when things look worse to come out the other side in a better place than you otherwise would have.
The recent market meltdown shows how important it is to have a solid strategy to stay invested when the going gets tough. So if you don’t already have your own plan, now is a good time to start. If there’s another leg down on the market, you’ll be glad you did. And if the worst is behind you, you’ll still likely find that with the right foundation and plan, you’ll be able to make better long-term financial decisions.
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Chuck Saletta has no position in any of the listed stocks. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.