A lot of people have been throwing around the "B word"–bubble– lately, and it’s making Wall Street nervous. It all started last week, when the Fed released its latest FOMC minutes. Some participants were clearly worried that excessive Quantitative Easing may cause another bubble in housing and in the stock market. Then Fed Chairman Ben Bernanke hinted that the central bank might “taper” QE sooner than many expected. He quickly shifted course, but the cat was out of the bag.
If the latest market activity is any indication, investors don’t know what to make of all of this "bubble talk." Just look at the past four trading days. On Monday, the Dow dove 180 points on Fed uncertainty and mixed earnings news. On Tuesday and Wednesday, the markets had their strongest two-day winning streak of 2014–due partly to the banking sector. And then today the markets have pulled back once again despite assurances from Chairman Bernanke on the soundness of the Fed’s policies.
While fourth-quarter earnings season excitement is smoothing out some of the bumps in the ride, I expect more choppiness ahead. And a lot of people are clearly seeing the same thing because my inbox has once again filled up with questions about whether it’s finally time to go to cash. If you’re one of those people, today’s blog is for you.
Now is not the time to bail out of the stock market. While the market boomed during 2013, the short-term choppiness we’re seeing now should bring us opportunities to buy premium stocks at attractive valuations. I can tell you with all certainty that there is money to be made now and throughout 2014 if you know what to look for.
That’s why I’ve put together this five-step system that will make sure you’re fully prepared for any volatility that could come your way. Print out this checklist and post it near your computer so that every time the media rolls out the bubble talk and you have the urge to sell, you’ll know exactly what to look for before making any major moves.
So, during any period of increased volatility or a temporary market sell-off, I recommend that you take the following five steps:
Step #1: Don’t Panic
I know it sounds like an oversimplification, but panic is a powerful force that will get you in trouble if you let it take over. Panic makes you think that you have to take action—any action—immediately. Panic will cause you to sell stocks prematurely and at their worst prices.
The best thing to do when the market starts to sell off is take a deep breath and quickly move on to step #2.
Step #2: Get to the Truth
The first question you should ask is, "What’s causing the sell-off?" Are your stocks dropping on sector news, global events or economic data? Any of these things could have little to nothing to do with your individual stocks, and joining the crowd by selling without the right information guarantees that you will sell at the wrong time.
Unfortunately, this is the fate of many investors because they don’t adhere to step #1 or #2. They’re in a "shoot first, ask later" mentality that causes them to lose money.
It’s not easy, but you must keep your wits about you and drill down to what’s really going on. Ask yourself, "Is a big company with a bad earnings report causing the market to go down or is some sort of systematic financial problem at play?" If a big-name company gets a downgrade because of supply issues, look at your company and see if the same issues apply and if it is a short-term or long-term impact.
We live in a very connected world, and news travels fast. It wasn’t so long ago when you would check your quotes in the daily paper and call your broker to make buy and sell orders, but nowadays, you just direct your browser to any of the major news sites and, if there’s a major sell-off, it will be right there on the homepage. Knowing the origin of the selling pressure will help you decide what to do next.
Step #3: Do a Systematic Check of Your Holdings
So, after you’ve taken a deep breath and found out what’s causing the sell-off, it’s time to look at your holdings. If you haven’t already, be sure to check your stocks in Portfolio Grader for free.
The grades allow you to immediately check the fundamental strength of your positions and if they have what it takes to survive a downturn and what it takes to come back from one. D and F graded stocks should always be sold immediately. These companies simply don’t have the fundamentals or buying pressure to bounce back from temporary dips. In general, these stocks will be the first to fall and the last to recover—not a position you ever want to be in. Good stocks (rated A or B in Portfolio Grader) are like fresh tennis balls—they can’t avoid market selloffs, but they bounce back quickly and with force.
It’s also a good idea to check the beta of your portfolio to see if you can expect your portfolio to swing wider than the market or run in line with it. Beta is a measure of systematic risk, or the sensitivity of a stock to movements of a benchmark (usually the market). A beta of 1 means you can expect the movement of a stock to match the market. So if a stock or portfolio had a beta of 1.10, that means the stock has historically moved higher and lower than the market by 10%. In a similar way, if an asset had a beta of 0.80, then it has historically moved -20% in relation to the market–both up and down.
Knowing what your beta is and if your stocks are working outside of those norms will help you identify problem areas and focus on those stocks. From there, you’ll be ready to buy, sell or hold…
Step #4: Buy, Sell or Hold
This is the time to take your action. You’ve already assessed the situation and have determined if there’s reason to believe a further downward slide will occur or not.
Have confidence in your decision and stick with it. While I’m no fan of taking action for action’s sake, if you decide that a stock should be sold or a buying opportunity has presented itself, you need to act on it.
Step #5: Have a Strategy
Sell-offs will expose weaknesses in your portfolio. Use your knowledge of which stocks were hurt the worst to trim your holdings in one area and increase your exposure in another. The lessons you learn during each boom and decline will make you a better investor and help you reach your financial goals.
I hope that you found this 5-step list helpful and that you will feel confident with the knowledge that you will be prepared for any market volatility that may come your way in the weeks and months to come.
And I can guarantee you that more volatility is on the horizon. Why is that? Because there is always a level of volatility around earnings season. Knowing that stocks will rise and fall and being prepared for both situations is part of investing.