Three Steps to Overcoming Losses in a Declining Market

“What should you do when the house isn’t in order?”

A good friend of mine asked this question back in 2011. At that time, key stock indices were plunging lower due to issues regarding the U.S. debt ceiling. There was uncertainty, and many wondered what would happen next. I remember this question now because the key stock indices nowadays are falling due to troubles in the emerging markets and there seems to be panic—similar to what we were experiencing when I first heard this question.

When key stock indices are declining, instead of panicking and selling every holding in their portfolio, investors have to be strategic and instead think with an open mind and a long-term perspective.

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The first step investors should take is to see where the troubles are coming from and if they are exposed to it at all. For example, these days, we see problems in the emerging markets are causing panic. If investors have a massive percentage of their portfolio invested in the emerging markets, then they should simply reduce their exposure. If they continue to hold their positions, and the markets continue to decline further, their losses will get bigger and it will be much harder to recover. If investors witnessed a drawdown of 25% in their portfolio, it will have to go up by more than 33% for them to just break even. Plus, reducing exposure not only protects investors from potential loss, but it also increases their cash position.

The second step investor should take is to exercise extra caution when key stock indices are falling. Investors should carefully screen the news and economic data, watching for any hints that suggest the sell-off may be easing.

At this point, investors should also be looking for companies that are getting “punished” for no apparent reason. This tends to happen when there’s panic and investors are selling. Companies with great prospects and track records get sold and decline in value. One of the greatest examples of this was the sell-off on key stock indices back in 2009. High-dividend-paying, mature, big-cap companies were selling at a discount. Johnson & Johnson JNJ, for example, traded as low as $40.00; it now trades above $86.00 and pays a hefty dividend.

Finally, the last step investors should take is to put their cash to work—hunt for value to buy, especially in the companies you’ve been targeting to buy for some time. A decline in key stock indices essentially creates a discounted market for investors who are looking to buy. For example, if investors can buy a stock that sold for $50.00, but has come down to $40.00 and not a lot has changed in terms of the stock’s fundamentals, investors see a discount of $10.00. If the stock pays a dividend, their yields are even higher. Essentially, less money buys more, meaning investors get a bigger bang for their investing buck.

For those who have already seen a loss in their portfolio due to the recent decline in key stock indices, let it be a lesson, rather than a factor of discouragement. In my opinion, learning from losses is hands down the best investing education you can get.

This article Three Steps to Overcoming Losses in a Declining Market was originally published at Daily Gains Letter