When markets are volatile there are a few common questions that are asked. I thought it would be helpful to notate them and also post the responses to them, as there is nothing more important in investing than mastering the psychology necessary to actually invest successfully. Below are a few examples:
1) It seems that the market is likely to continue lower, should we go short or exit positions?
It is impossible to consistently predict short-term market movements. Some pullbacks are extremely short and others turn into bear markets. If you were to get out every time that the market exhibits volatility, you would never be able to last long enough to make real money from stocks going higher, as markets are inherently volatile. In addition, when do you know when to get back into the market when you are just speculating on short-term price movements? This creates a vicious cycle of speculation and market-timing that is highly unproductive to long-term investing success.
2) Should we buy puts to protect the portfolio?
Buying puts is somewhat akin to buying insurance but often it is even less attractive. First of all, you have to get both the direction and timing right on whatever you are buying puts on. As opposed to when we sell puts, the purchaser of puts has time constantly working against them, as these puts will expire at some point. This can make buying puts psychologically taxing; you might be correct about the market direction after you buy a put, but when do you actually close it out? If you close too early you lose the protection after making a bit of money on the put, but if you wait too long and the stock or market recovers, you risk the put expiring worthless. Once again this bring us to market timing, which is a losing game to play.
3) My account is down this amount in the last day, week or month, what should we do?
Stocks go up and down – this is essential to understand before getting started investing. When you buy a stock, you are buying fractional shares of a business. If you own a restaurant, farm, or a bank, would you sell just because general stock market prices had declined over the last few days or weeks? You certainly would not, and it is essential to keep that perspective when you are investing in publicly traded companies. Now the benefit of publicly traded companies is that when “Mr. Market” offers you a discount, you can take advantage of it and buy more. This requires the expertise to be able to analyze the quantitative and qualitative characteristics of the business and the patience to see the investment through. If you can master these skills or work with someone that can, this is how you can make a lot of money through investing in your lifetime. Stocks can always drop further, so dollar cost averaging is generally a wonderful tact to take.