Not every investment pans out. Some trades backfire. And hoped-for profits on some bets give way to painful losses or missed out gains. So, what do you do if you're wrong about the market?
"I don't think there is an investor alive who hasn't faced this dilemma," said Jamie Cox, managing partner at Harris Financial Group.
When investing, getting it wrong is part of the game. Mistakes happen due to faulty investment analysis. Trying to predict the future and incorrectly timing the market might trip you up. Or you might let emotions hijack the decision-making process.
Still, the sooner you course-correct and get your portfolio back on track the better, investment pros say. "Cut your losses and move on," said Cox.
That's true whether you bought a hot stock at the top right before it nose-dived or purchased shares of a company that quickly morphed into a money-loser. You might have been wrong about the market and slashed your stock exposure to lower the risk to your portfolio amid fears of a recession or bear market.
Why You Were Wrong About The Market
The stock or mutual fund you bought is performing poorly. Should you dump it, hold it or buy more? It depends on why the shares are in free fall and how much they're falling.
If you're buying diversified mutual funds or ETFs tracking a broad market index like the S&P 500, it's best to hold on. Markets as a whole, over time, recover and with long-term money in funds, time is on your side.
But knowing when to cut losses short on individual stocks is different. You'll want to limit losses to levels that won't set you back too far. Investor's Business Daily finds it best to sell losing individual stocks when they drop 7% or 8% from your purchase price.
Outside of that rule, you must monitor your individual stocks. Ask yourself if the price drop is due to an extraneous event, such as war. Such moves spark fear and have nothing to do with the outlook for the stock. It's a totally different story, though, "if it's a company-specific problem," said Cox.
If it's a broad sell-off of the stock and the business hasn't been impaired, it might not make sense to sell, says Cox. That's if the stock hasn't fallen 8% from your purchase price. But if your stock is falling, dig deeper to see if the problem is serious enough to derail the company's future growth.
Headwinds such as government investigations into company wrongdoing, a slowdown in earnings due to a new entrant stealing market share, an accounting scandal, or sudden dividend cut that suggests a cash flow issue, should be viewed more seriously. And again, know to cut losses no matter what — if they hit 8%.
"If something really knocks a hole in a company's profitability or you recognize that the business just isn't going to be the same (from here on), then you need to cut bait," said Cox.
When trading his own account, Cox says he asks himself this question when a stock begins to underperform short-term: "Is this company going to be here 10 years from now?"
If the answer after an objective analysis is yes, and the price drop is just a speed-bump, it's OK to hold it and wait for a recovery, he says.
And if the hard-hit stock or fund is sitting in a traditional IRA, a good strategy to consider is converting to a Roth IRA, says Cox. The reason: the lower value of the stock means you'll pay less in income taxes on the conversion. You'll also benefit from the eventual rebound in the stock price and tax-free withdrawals from the Roth IRA.
However, if you don't have confidence that the stumbling company has staying power or the ability to book profits at the peppy pace you once envisioned, you probably should not own the stock, says Cox.
Reviewing a company's fortunes purely from a business-owner perspective has big benefits.
"It eliminates all the short-term thinking and what-ifs," said Cox. "What if a recession comes? What if we have another pandemic? All the what-ifs get completely reduced to insignificant moments in time."
Playing Devil's Advocate Can Cut Losses
Even top-performing mutual funds sometimes must acknowledge that a stock they bought isn't the big winner they envisioned. Tom Hancock, portfolio manager for GMO Quality Fund, a 2023 IBD Best Mutual Funds Award winner, says it's important not to wait too long to recognize when you've been wrong about the market.
"Sometimes when we buy a business that we think is high-quality, bad things start to happen," said Hancock.
When trouble surfaces, the research team circles back to make sure its initial investment thesis remains intact.
"We do our best to have people play devil's advocate and we have to be willing to cut our losses if we conclude there's evidence that it's not a great business anymore," said Hancock. "It's hard to change your mind about a stock that hasn't been working. Looking back at our track record, we've been too slow to make those changes."
Fixing A Big Market Call Gone Bad
Despite Wall Street preaching to stay the course and avoid timing the market, many investors do jump in and out of the market. And they often do so at the wrong time, costing themselves a lot of money.
Consider a risk-averse investor who fears a looming recession and a potential stock market pullback who goes to cash to avoid the downturn. Often, they never get back in. And they miss out on gains if the market keeps heading higher.
"To make a giant call to be out of the market is generally a mistake because no one can accurately predict what's going to happen," said Patrick Fruzzetti, managing director, and partner at Rose Advisors at Hightower.
Fruzzetti recommends a recovery plan in which you reenter the market slowly. He recommends putting a set amount of dollars back into the market at regular intervals, a strategy known as dollar-cost averaging.
"You have to have a plan and follow it," Fruzzetti said. "And it doesn't matter where the market is."
What you want to avoid is another market-timing mishap. That includes jumping back in at a market high with the wrong stocks. Doing so only reinforces the earlier mistake of getting out and missing a rally. The fear of missing out on future gains, dubbed FOMO, can be just as damaging to a portfolio as selling at a market bottom.
If the fundamental facts about your company change, Fruzzetti says, you must accept that and make changes, too. "I just think drastic changes are never healthy," he said. "The only thing you can do is move forward. The most successful investors are ones that stick to a plan. And if they make a mistake, they have a short memory."
Getting back in the market with a lump sum is also an option, says Cox. In fact, investing a lump sum outperformed dollar-cost averaging 68% of the time, according to a recent Vanguard study that spanned a period from 1976 to 2022. "It's time in the market, not timing the market," said Cox.
The big lesson: making a bad market call is learning from your mistakes. "Get back in and don't make the same mistake again," Cox said.
