How Can You Avoid Mistakes in an Economic Downturn

The economic downturn that began earlier in 2020 resulting from the Coronavirus outbreak has led to a period of economic contraction that some economists are calling a recession.  The fallout of the pandemic has been disjointed, leaving some Americans struggling to pay their bills, while other Americans are largely unaffected financially.  Whether or not the downturn turns into an actual recession or not, here are some commons mistakes to avoid during periods of economic downturn that can derail your financial plans.

Neglecting your emergency fund

Most financial planners (including this author) recommend having three to six months of non-discretionary living expenses set aside in a liquid fund that is easily accessible, in case of a financial emergency.  Economic conditions like the one we are encountering are the very reason it is so important to have an emergency fund!  For those who are experiencing financial hardship resulting from the economic downturn, tapping the emergency fund now can help ease the sting of job loss or reduced income in the short term.  Once individuals who tap their emergency fund are back on solid financial footing, they will need to replenish their emergency fund to previous values.

On the other hand, many Americans who have not experienced job loss or loss of income are cutting back on spending and saving more money in recent months.  In many cases, these individuals may have grown their savings to contain more than three to six months of living expenses in their emergency fund.  With the low to non-existent returns earned in checking and savings accounts in today’s low interest rate environment, these individuals would be financially better off investing these excess funds in an investment strategy tailored to their risk tolerance and investment goals.

Trying to time markets

Many investors believe they can avoid incurring market losses by selling securities before they decline too sharply and buying securities again when they are poised to rebound.  This strategy is commonly known as market timing and is done by many investors in an attempt to avoid risk of loss (see below).

Market timing to avoid losses is a very difficult strategy to execute successfully.  First off, investors need to know the right time to sell their positions to avoid loss.  For a swift sell-off like we experienced in March, much of the damage was done in a matter of days.  The second part necessary is to successfully determine the correct time to re-enter the market by purchasing securities again.

As you can imagine, there are no clear signals or alarms that indicate that it is time to exit or re-enter markets, and investors can miss out on valuable wealth building opportunities.  According to a recent Gallup poll, stock ownership (directly or through mutual funds) among Americans has shrunk to 55% in 2020 from 65% in 2010, partly because investors frequently do not recognize opportunities to buy back into stock positions once they have sold and are stuck on the sidelines waiting for a signal or sign that never comes.

Confusing volatility with risk of loss

It can be very unnerving to watch equity markets experience sharp declines in value like we experienced in March of 2020.  But periods of extreme market volatility (both up and down) occur from time to time in healthy functioning markets as new information is absorbed and processed by investors.  Volatility is the price we pay as investors for the higher investment returns earned by stocks over long periods of time. Sharp downturns in equity markets can lead some investors to mistakenly believe that they risk their investments in stocks going to zero as a result of the market downturn.

Risk of loss is investing in a business whose value is lost because of bankruptcy or business failure.  When a broad market index like the NASDAQ, S&P 500 or DJIA experiences a sharp sell-off like the one in March of 2020, it does not mean that all of the companies listed on that index are in danger of going out of business.  It simply means that new information, in this case the effects of the Coronavirus pandemic, is being processed by investors and baked into the price of all stocks.  This information processing operation occurs every single day that markets are open.  The only investors who experience risk of loss are those who realize the loss by selling their securities in a panic.

Navigating economic downturns is difficult enough without adding avoidable mistakes to the situation.  Avoiding these common errors can help keep your financial plans on track through the rest of 2020 and beyond.

 

Sources: Dimensional Fund Advisors, The Wall Street Journal, Gallup