‘The value of shares can go down as well as up' is the warning given on everything from stockbrokers' brochures to investment magazines. However, these words of caution are not much comfort when the stock market starts to tumble, along with the value of your shares.
The gut reaction of many private investors is to sell their shares quickly in a falling market to avoid incurring further losses. However, this is more often than not the worst thing that you can do.
Here are some reasons not to sell in haste:
Historically, falls in share prices, even significant falls caused by stock market crashes, level out over time. For example, the FTSE All Share Index was back to the level it had reached before the crash of October 1987 within 2 years and had more than doubled its pre-crash value within 10 years*.
Good and well researched investment decisions should withstand a bear market (a falling market) as well as a bull market (a rising market). Remember that share prices are falling due to a lack of confidence in the market as a whole and not because of inherent problems with the company in which you have invested.
Losses incurred on paper do not become real until you sell your shares, therefore it is best not to sell shares when markets are low unless you are forced to for a specific purpose. If you hang-on, past experience shows that the market is likely to recover and you will be able to sell your shares at a better price in the future.
Panic selling has a cumulative effect and can quicken the downwards trend of a falling market. If you, and other investors like you, hold tight then the worst excesses of a stock market crash can be avoided.
Golden Rules in a Falling Market
There are a number of things that private investors can do to protect themselves in a falling market. Here are some golden rules for survival, many of which apply to investing in general:
DON'T PANIC or sell in haste - you may regret it later!
TAKE A LONGER TERM VIEW - 5 years is a sensible minimum. As described earlier, historically markets have always recovered given time.
ENSURE THAT YOUR PORTFOLIO IS BALANCED with shares in companies in different sectors of the market. Ensure that ‘blue chip' companies form the basis of your portfolio. These are large well-established companies, often high street names, which tend to keep their value over the long term.
ADOPT A DRIP-FEED APPROACH to investment, putting a little money in the stock market at regular intervals. This means that you will be buying shares at different times and at different prices, sometimes high and sometimes low, but overall you will pay a price somewhere in the middle, and avoid investing a lump sum at the top of the market. Investing in unit and investment trust saving schemes and participating in an investment club are easy ways to adopt this approach.
FOLLOW THE PROFESSIONALS who view a falling or low market as a buying opportunity - to purchase what are fundamentally sound investments at a bargain price.
What to do if you do need to get out of a falling market
Ideally, you should only invest money in the stock market which you can afford to forget about, so that you can sell your investments at a time of your own choosing and will not be forced to sell when share prices are low.
It might be, however, that for one reason or another you do have to sell shares when the market has fallen and you are not able to gain maximum profits.
In this instance, take comfort in the fact that if you invested in the shares more than a couple of years ago, you will probably have increased the value of your investment by more than if you left the money in the building society.
Pensions It is a common fear for those people who have their pensions invested in the stock market that when they reach retirement age it might be a bad time to sell their investments and this will in turn affect the value of their pension income.
In reality, pension providers allow for stock market fluctuations and usually take their clients money out of the stock market at suitable point some years before they are due to retire and reinvest the money in a more predictable type of investment.
Stop Loss Policies Although the best advice for most investors in a volatile market is to hold for the longer term, more active investors sometimes set up stop loss systems in order to preserve the value of their portfolios. Stop loss systems are a controlled and planned way to sell investments. A stop loss might work as follows:
Assume that you have bought shares for 100 pence (£1), you might decide that you wish to set a stop loss of 20%. Therefore, you would automatically sell your shares if the share price fell below 80p, i.e. by more than 20% of the purchase price.
A stop loss can either be set on the purchase price of the share or adjusted as the share price moves up. In other words if the shares move up to 200p you would sell at 160p (200p less 20%). This is known as a rolling stop loss. Of course stop loss limits should not be adjusted as shares prices fall or they will be ineffective.
*Source - CSO Financial Statistics January 1991 and December 1997.