Market Drops Are Scary for Investors, but They Are Well Overdue

Investors should remember that market downturns are "completely normal" and avoid letting short-term volatility dictate their long-term investment strategy, advises Dave Alison of Alison Wealth Management. Alison emphasizes the importance of diversification during these times.

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“These volatile market periods can be a good opportunity to strategically rebalance a portfolio, reallocating gains from well-performing investments to underweight positions,” he said.

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Advisers note that while recent market losses have been steep, they haven't been widespread. This could signal a potential "great rotation" from tech stocks to assets that might perform better in a lower-rate environment. Although the AI craze has dominated the stock market lately, a broader range of stocks within the S&P 500 and beyond are starting to show better performance.

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Small-cap stocks, in particular, are experiencing a resurgence. Jason Pride, chief of investment strategy and research at Glenmede, expects this trend to continue. He explains that small-caps are more sensitive to interest rates. Higher rates have made debt more expensive for these companies, so a Fed that begins cutting rates "should benefit small-cap companies whose floating-rate debt will reprice at lower levels, boosting earnings."

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According to Glenmede’s calculations, small-caps are currently valued near the 55th to 65th percentile, meaning they've been valued higher about 35% to 45% of the time. In contrast, large-caps are near the 80th to 85th percentile in valuation.

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For those investing in exchange-traded funds (ETFs), Pride suggests favoring ETFs tracking the S&P Small-Cap 600 Index, which has a profitability requirement for inclusion, over ETFs tracking the Russell 2000, which lacks such criteria.

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Money managers caution against retreating into cash during market turmoil, calling it a classic mistake. Once people move into cash, they often remain there and miss market rebounds.

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Research by Fidelity Investments highlights the cost of missing just a few days of a recovering stock market in the U.S. If a hypothetical investor started with $10,000 and either stayed in a portfolio tracking the S&P 500 from January 1, 1980, to June 30, 2022, or missed the best 5, 10, 30, or 50 days during that period, the difference in returns was significant.

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An investor who remained invested throughout would have, with dividends reinvested, a hypothetical $1.1 million. In contrast, investors who missed the best 5, 10, 30, or 50 days had returns that were 38%, 55%, 84%, and 93% lower, respectively.

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Marguerita Cheng, a financial adviser and CEO of Blue Ocean Global Wealth, reminds clients that "time in the market is more important than trying to time the market."

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Understanding one's risk tolerance is challenging. Investors often see markets as less risky when they're rising and more risky when they're falling. Advisers recommend reflecting on how recent market turmoil affected your feelings and actions regarding your portfolio. One effective way to gauge true risk tolerance is to examine past market drops: Did you move to cash and later regret it, or did you stay invested and reap long-term gains?

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Market volatility, while unsettling, is a normal part of investing. By maintaining a diversified portfolio, resisting the urge to move to cash during downturns, and accurately assessing your risk tolerance, you can better navigate turbulent times and stay on track with your long-term investment strategy. Diversification, strategic rebalancing, and staying invested through market cycles are key principles that can help investors weather short-term volatility and achieve long-term success.

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