When markets fall, here’s what to avoid doing

When stock market fall sharply, as they did last week for a period, it is important to keep a cool head and take the long view rather than making rash decisions.

Several reasons lay behind the stock market turbulence, chief among them concerns over the strength of the US economy on the back of weaker-than-expected US jobs data. This has raised fears of a recession and questions about whether the US central bank – the Federal Reserve – is too “behind the curve” by not lowering interest rates. As the US stock market is the world’s most influential, when investors become more cautious about its prospects it tends to impact sentiment in other equity markets.  

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Japan also played a big role in the sell-off, as a surprise decision to raise interest rates caught markets off guard, causing the yen to strengthen, which negatively impacted share prices. This has also more broadly negatively impacted investor confidence, contributing to increased market volatility beyond Japan.  

Below, we briefly offer some pointers on what to do, and what to avoid doing, when stock markets fall sharply in a short space of time.

Don’t panic, and think long term

As history shows, for those willing to take a long-term perspective, sharp dips end up being a mere footnote in the grand scheme of things. At times of stock market turbulence, it is worth remembering that volatility is part of the deal in investing in equities. It is the price investors pay for the fact that, over the long run, putting money into shares rather than leaving it in cash will yield greater rewards.

For those concerned that they may panic-sell when markets fall on bad news, it is well worth considering drip-feeding money into the market. A regular plan, involving investing at the start of every month, for example, does away with the risk that you might put all your cash into the market just before a nasty dip.

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This strategy benefits from what is known as pound-cost averaging. When stock markets fall, the regular investment purchases more shares or fund units. Conversely, when stock markets rise, fewer shares and fund units are bought.

Sharp falls are not unusual

As Simon Webber, head of global equities at Schroders, says, it is important to remember that sharp falls are not especially unusual in equity markets.

Webber says: “There was a violent sell-off in equities (at the start of last week), punishing consensus and crowded trades. However, this must be seen in the context of exceptionally strong equity markets since October 2023 (by mid-July, the MSCI All-Country World Index was up circa 32% from its October lows) and a correction is perfectly healthy and normal.”

Diversify, diversify, diversify

While it doesn’t sound very exciting, maintaining a balanced and well-diversified portfolio is the best way to ride out short-term market falls.

Diversification involves having a mix of investment types, primarily shares, bonds and commercial property. Diversification can also be achieved through mixing large and small companies, having a spread of sectors and regions, and by having exposure to different investment styles, such as growth and value. Allocating to alternatives, such as infrastructure, private equity and commodities, can also improve diversification.

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The theory is that different types of investments are unlikely to all outperform or underperform at the same time, which reduces the volatility of your overall portfolio. A mixed investment approach gives a portfolio ample opportunity to grow, while guarding against short-term volatility.  

Have some cash ready to invest

Stock market volatility also brings opportunities. It is worth considering keeping a small part of your portfolio in cash, or be ready to add some through new ISA or SIPP contributions. Having cash ready to invest means you are positioned to act quickly, as and when the next market sell-off occurs.

Is it a bubble or normal ups and downs?

As mentioned, declines are part of the normal ups and downs of investing and stock markets occasionally depart from their long-term upward trajectory.

However, sometimes stock valuations race so far ahead of reality that they fail, or take a very long time to recover – a so-called bubble.

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Perhaps the clearest example of this over the past 40 years was the bubble - in Japanese stocks and the country’s property market - which burst in the early 1990s. It took 34 years – until February 2024 – for Japan’s Nikkei 225 index to recover and hit a new record high.

As ever, the key to mitigate the risk of bubbles is to be diversified rather than being overexposed to a certain region, sector or theme.