How to Lose Money When Stocks Drop

Many individual investors will lose money because of the stock market’s decline in recent months — but not because of the economic reasons (e.g., recession, subprime loans) commonly reported.   Rather such investors will lose money because of two different types of forces at work in their own minds.

web-1390-112013-120305_dollar_01.jpgThese forces involve different parts of the brain.  One part of our brain governs emotions and moods.  Another part governs powers of intellect and analysis.  Either part can unnecessarily cause investors to turn short-term paper losses into long-term real losses when they sell out of the stock market after it drops.

The most common responses to market declines are emotional, causing fear and anxiety about the future.  From an evolutionary standpoint, it is understandable that our bodies viscerally want to make a change when we encounter situations (like declining stock values) that we don’t like or understand.

When it comes to investing, however, these tendencies can cause us to lose money.

Even though we may rationally know that stock markets have always eventually rebounded (almost always within two years and most often in less than a year), at a gut level we still find ourselves wanting to jump from what feels like a sinking ship.

History shows us, however, that it is critically important that investors learn how to manage this emotional reaction.  When people get out of the stock market after it drops in value, they miss the best opportunity to participate in the rapid growth that tends to follow steep market declines.

For instance, in 2003, the first year after the declines that occurred from 2000-2002, the S&P 500 stock market index grew by 28%.  Small cap and international stocks grew even faster that year.  Similarly, the S&P 500 averaged 18% growth during the twelve months following the announcement of each of the last four recessions (beginning in 1980, 1981, 1991, and 2001).

However, to enjoy such growth, investors must resist the urge to sell their stocks when markets have declined.  Some observers, noting that the market has dropped about as much as it did on average following the announcement of the last four recessions, assess that we will not see further declines.  Even if stocks do drop further though, history tells us that a well-diversified portfolio will eventually recover its losses.

Sometimes, however, people do not have the option of waiting for stocks to rebound.  Because they need cash, they have to sell their stocks and thus “lock in” losses.

When this occurs, the breakdown is not an emotional one. Rather, it involves the side of the brain involved with critical thinking and planning.

This side of the brain depends on knowledge. Unlike the biologically driven urge to flee danger or pursue pleasure, critical thinking requires knowledge that is accumulated through experience and study.

For this reason, people who have learned that it is normal for stock markets to fall sharply can avoid “selling low” by keeping enough money out of the stock market to take care of their near-term cash needs.  With other sources of cash available, they are not forced to sell during one of those periods when stock markets decline – which happens, on average, about one out of four calendar years.  They can wait for stock markets to rise enough to eliminate the “paper” losses.

There are, of course, reasons people lose money permanently in stocks other than getting upset by declines or not planning for cash flow needs.   For instance, the lack of diversification can also lead to permanent losses in the stock market.

But for many people, the best way to avoid permanent stock market losses is to learn that stock market declines are not only inevitable but, with sound mood and mind, imminently manageable.