When Markets Dip, Don't Drop Out

An extreme downturn in the market can shake your confidence, but resisting the urge to flinch can pay off. 

To demonstrate, we'll look at how three hypothetical investors—the Stalwart, the Reactor, and the Waffler—respond to the market over the course of 40 years. 

The Stalwart, the Reactor, and the Waffler all start in the same place: They begin their careers in 1983 at salaries of $18,580 and receive annual raises of 3%, as well as 10% promotion bumps every five years. By 2022, they're making $112,560 a year. 

They start investing at age 26, saving 10% of their annual salaries. Initially, they're all aggressive—with portfolios comprising 50% large-cap stocks, 25% international stocks, 20% small-cap stocks, 5% cash—and then shift into increasingly conservative allocations over time. 

Forty years later, despite their shared origin stories, our investors' portfolios differ in size by hundreds of thousands of dollars. Why? As we'll see below, how they reacted to bad markets pretty much determined their destiny. (Spoiler alert: The person who reacted the least ended up gaining the most.) 

This disciplined investor sat tight and continued to invest, no matter how the market performed. The Stalwart shifted to a moderately aggressive portfolio (45% large-cap stocks, 20% international stocks, 15% small-cap stocks, 15% bonds, 5% cash) at age 39 and then moved to a moderate allocation (35% large-cap stocks, 15% international stocks, 10% small-cap stocks, 35% bonds, 5% cash) at age 52. As retirement neared, the Stalwart's portfolio had grown to more than $783,530.

The Waffler followed the same allocation plan as the Stalwart, but this wary investor moved almost all his money out of the market after every year of losses. However, he didn't completely withdraw: He continued to put 10% of his salary in 3-month Treasury bills whenever he was out of the market.

Then, if the market was up after two years, the Waffler reinvested in a portfolio suitable for his age. This strategy resulted in an ending balance of $437,418, cutting his potential growth by more than 44%.

This investor stuck it out through a brief bear market in the late '80s as well as the early 2000s recession. Then, midway to the Reactor's retirement, the 2008 financial crisis hit. He pulled all his money out of the market—and kept it out. 

He continued to put 10% of his salary in 3-month Treasury bills with hopes of recouping some of his losses. But at the end of 40 years, he only managed to save $357,535, cutting his potential earnings by almost 55%.

Bad markets can definitely cause big feelings, but it's generally not a great idea to let emotions take control of your portfolio. 

A better approach would be to make a plan you can stick to no matter what the market's doing. You can absolutely modify those plans as your goals or situation change, but such adjustments should occur without the influence of any temporary gut feelings. Otherwise, the consequences could be with you for life.