At Pearler, we believe that shares are best held for the long haul, regardless of what the market’s doing in the short term. However, we also know some investors tend to do the opposite: panic or succumb to fear when the market dips and sell their shares at a loss. Investors sell during a downturn for many reasons, and this article aims to uncover some of the main ones.
On the surface, it doesn’t make a lot of sense to sell when the market’s down. After all, isn’t the point of share investing to make money?
However, it’s a widespread phenomenon, with many sellers shedding their assets as soon as the market shows signs of volatility. The reasons could be rooted in psychological factors, or they could be more practical. Whatever the case, selling during a downturn isn’t a practice we endorse here at Pearler – but we are acutely aware of its prevalence. So, we thought we’d examine why it happens.
What are some of the consequences of selling during dips?
Besides the obvious financial loss that can accompany panic selling, there are other downsides of selling during a downturn.
For one, investors may miss out on subsequent market recovery. There’s good evidence that markets tend to rebound fairly well after a dip, often quite quickly, too. Historically, market corrections – where the market drops between 10-20% – typically only last for 3-4 months . While this doesn't account for specific stock crashes, it is something to factor into any decision.
Selling frequently can also mean spending more money on fees like brokerage, as well as interrupting the power of compound interest . By offloading their assets at inopportune times, investors run the very real risk of losing all of that sweet potential growth.
Lastly, consistently selling at a loss can take a huge emotional toll. There’s the anxiety of watching the value of your investments go down, but then there’s also the potential for seller’s remorse if they go back up. Panic sellers might also start to doubt their own decision-making abilities and experience anxiety about getting back into the market. This can create a negative cycle that’s mentally draining and detrimental to their long-term investing success.
Who do some investors sell in a downturn?
From emotional factors to more strategic ones, here are some of the primary reasons investors sell their assets when the stock market dips.
Sheer panic
Watching your investments drop is an understandably stressful experience. Many investors sell out of panic and fear, concerned that if they don’t, they could stand to lose even more money. Getting rid of their assets is effectively a way to escape the market as quickly as possible. It may also offer emotional relief from the anxiety of seeing their portfolio go south.
Loss aversion bias
Loss aversion bias is a psychological phenomenon whereby investors fear losing money more than they value gaining it. It’s a behaviour backed up by plenty of research, with studies showing that the pain of losing is twice as powerful as the joy of gaining.
This bias can result in emotional decision-making and irrational selling during downturns, potentially exacerbating losses.
Trying to time the market
Timing the market is rarely an approach that works out – find out why here and here – but some investors become overconfident on the off chance it does. They might adopt the belief that they can accurately predict market movements, potentially leading to poor investing decisions and mistimed selling.
Following the crowd
Herd mentality can have a powerful effect on investor behaviour. If there’s widespread concern over a share’s performance and investors start selling, it can cause a cascade of other investors offloading their shares, too.
Need for liquidity
Some investors simply need the capital they’ve invested for something else. This could be urgent expenses like medical costs, losing their job, or other unexpected financial obligations they don’t have the funds for.
It could also be to free up capital they’d prefer to put into a different investment, perhaps one that’s gaining momentum while their current holdings are doing the opposite.
Stop-loss orders
A stop-loss order allows an investor to automatically sell an asset at a pre-determined price. The idea is that it can help investors limit their losses should the market continue declining. One of the drawbacks of stop-loss orders is that it can lead to selling at a less-than-ideal price. This is especially the case if that lower price is only short term and the market’s able to rebound.
Portfolio rebalancing
In some cases, a dip in the market can throw an investor’s asset allocation off balance. They might then choose to sell off some of those assets to help rebalance their portfolio and bring it back to a state of equilibrium (and more in line with their strategy).
In a similar vein, a dip could expose weaknesses in a portfolio. Say someone predominantly invested in tech stocks. If the tech sector experienced a decline, that investor might notice a lack of portfolio diversification and sell some stocks before reinvesting in other sectors.
Margin calls
Margin trading is when someone takes out a loan with a broker so they can invest. The major advantage of a margin loan is that it allows investors to increase their purchasing power – a bit like a home loan.
However, if the value of their investments dips below a certain level, it reduces the loan’s collateral and the broker sees the investment as higher risk. In this instance, the investor generally has a couple of options: either deposit more cash to secure the loan or sell off some of the investments to improve the loan-to-value ratio. This scenario is known as a margin call.
If the seller doesn’t meet the margin call by either adding funds or selling their assets, the broker has the right to sell the investments – possibly at a loss.
Tax loss selling
It might seem counterintuitive, but several investors actively seek out opportunities to sell at a loss because it can offer tax benefits. We’re not recommending you do so, but an investor could use capital losses to offset capital gains from the same financial year – potentially reducing their tax liability.
Taxes can be tricky to navigate. For anything tax-related, we always suggest chatting to a qualified tax accountant who can provide individual advice.
Strategic investing
Some experienced investors also sell during dips as a strategic move, using short-term trading approaches that capitalise on market volatility or re-entering the market at an even lower price. But these tactics typically require a high level of skill and they’re incredibly risky, relying on precise market timing to be successfully executed.
The ATO also has strict rules on selling shares, claiming the tax advantages of a capital loss and then re-purchasing the stock soon after. Find out more here .
Four alternatives to panic selling
Instead of selling as a knee-jerk reaction to market volatility, what can you do to try and manage your investments more strategically? Here are some options to think about.
Diversification
A diversified portfolio may be more resilient to market downturns. If some of your assets go south, you may have others that can act as a buffer or counterweight. For instance, many investors like to put their money in bonds and commodities like gold because they typically perform inversely to shares.
Other ways to diversify include spreading your investments across different sectors, geographies and asset classes; and investing in exchange-traded funds (ETFs) . Most ETFs offer instant diversification , so if the value of one holding slides, others may stay afloat.
Dollar-cost averaging
Dollar-cost averaging is where you invest fixed amounts at regular intervals, regardless of what the market is doing. The point is to effectively smooth out any peaks and troughs in the market by averaging out your purchasing prices.
The advantage of implementing a dollar-cost averaging strategy is that it can remove the emotional element of investing. By sticking to a set investing schedule, you may be able to avoid the temptation to sell in a panic – instead, boosting your investments regularly with a long-term view.
Buy-and-hold investing
Another investing strategy that could help combat panic selling is buy-and-hold investing. This is where you buy assets with the goal of holding them for the long term, withstanding any market fluctuations in the short term.
Once again, this could help you mitigate the emotional rollercoaster of investing and resist the urge to sell when the market is down.
Compound interest
Compound growth allows your investments to grow exponentially over time. The way it works is that your returns generate additional earnings, either through reinvested dividends or capital appreciation.
Offloading investments can interrupt this growth while remaining invested can let compound interest work its magic. While returns are never guaranteed, this is something to keep in mind if you're ever tempted to sell.
Maintaining a long-term perspective
Keeping your focus on your long-term goals can really help you weather any market storms that come your way. When you know your objective is to build wealth over time, you may be able to avoid the impulse to sell as soon as things get rocky.
A clear investing roadmap can support you in maintaining that perspective. It should clearly outline your timeline, your risk tolerance and your optimal asset allocation. It should also have a specific financial goal so you can keep your eyes on the prize (and not on minute-by-minute market updates). Other ways to try and maintain a long-term perspective include automating your investments and reviewing your portfolio at set intervals rather than checking it constantly.
Maintaining a clear head when the market dips and trying to focus on the long term isn’t always easy, but it can be done. Tuning out the noise and sticking to your guns can help you stay the course and avoid rash decisions.
Happy investing!
