What to know about a market sell-off

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Often, the word sell-off is used in conjunction with market volatility, but you may wonder what, exactly it means, especially when it comes to your money. A market sell-off occurs when a large pool of investors decide to sell stocks. When they do this, stock prices fall as a result.

A market sell-off may be due to external events, such as when regional lockdowns were announced following the escalation of the COVID-19 crisis. But sometimes sell-offs can be triggered by earnings reports that failed expectations, technological disruption, or internal shifts within an industry.

During a market sell-off, stock prices tumble. That stock volatility might lead other investors to wonder whether they should sell as well, whether they should hold their current investments, or whether they should buy while stock prices are low.

There is no “right” answer for whether to buy, hold or sell a stock during a market sell-off, but understanding the nature of a sell-off — as well as the purpose of your investments — can help investors decide on the right strategy for them.

Related: Shorting a stock explained

Understanding Bull Market vs. Bear Market

Understanding the overall market environment (as well as common stock market terms) can help investors understand how sell-offs exist within the market.

It’s not uncommon to see references to a bull market and a bear market. A bull market is when the stock market is showing gains. There are no specific levels of increase that indicate a bull market, but the phrase is commonly used when stocks are “charging ahead” and is generally considered a good thing. A bear market, on the other hand, is typically used to describe situations when major indexes fall 20% or more of their recent peak and remain there for at least two months.

There are also “corrections.” This is when the market falls 10% or more from a recent stock market high. Corrections are called such because historically, they “correct” prices to a longer-term trend, rather than hold them at a high that’s not sustainable. Sometimes, corrections turn into a bear market. Other times, corrections reach a low and then begin to climb back to a more level price, avoiding a bear market.

What To Do During a Market Sell-Off

A sell-off can make news and can make investors edgy. After all, investors don’t want to lose money and some investors fear that a sell-off portends more bad news, like a bear market.

Other investors see sell-offs as an opportunity to buy stocks at lower prices before the market bounces back. But a sell-off or correction may not trigger a dramatic change in every investor’s portfolio. That’s because a sell-off or correction may be limited to a certain sector or group of stocks, such as if a tariff impacted select companies.

So, what should an investor do during a market sell-off? That depends on the goals of an investor. Market sell-offs are “normal” fluctuations of the market, and investors who have a diversified portfolio may not do anything. Others may choose to either buy or sell—and neither decision is one-size-fits-all.

Pros & Cons of Selling During a Sell-Off

Some investors may get spooked and sell stocks in fear that the market will slide further. But while taking money out of the market may give investors confidence and cash in their pockets, removing money from the market might make it hard for investors to decide when to re-invest in the market in the future. As a result, they may miss opportunities to take advantage of compounding interest in investments.

Pros & Cons of Buying During a Sell-Off

Other investors may see a sell-off as an opportunity to invest when the market is down. They might buy stocks at a lower price, then wait for the market to bounce back. But a market sell-off may not necessarily be the optimum time to buy stocks, especially if it’s unclear what’s driving the sell-off.

Many investors pride themselves on their ability to “time the market” or buy stocks right before they begin to rise again. But the truth is that “timing the market” often relies on luck, deep knowledge of the industry, timing or a combination of all three.

For many investors, the best way to “time” the market may be to invest when they can afford to do so in a diversified portfolio and allow their money to ride out the highs and lows of market movements.

Why Risk Tolerance Matters During Market Sell-Offs

Understanding your own risk tolerance and investment goals can help an investor decide how to handle a market sell-off.

Risk tolerance is the amount of risk an investor is willing to take and depends on several factors:

  • Risk capacity: This is your ability to handle risk. For example, people who are depending on their investment portfolio to fund their lives, such as retirees, may have a lower risk tolerance than young people who have years for their portfolio to make up losses.
  • Benchmarks: Are there benchmarks their portfolio has to hit at set periods of time so that their portfolio reaches the goals they have set?
  • Emotional tolerance: All investors have different emotional capacity for risk tolerance, that may be independent of the actual amount of money within the portfolio.
  • Understanding your personal risk tolerance can help you build an investment portfolio that may be less vulnerable to market sell-offs and can also give you less trepidation during a sell-off.

How Diversification Can Help Protect a Portfolio From Sell-Offs

portfolio diversification strategy may be different between investors, but the underlying anchor of any diversification strategy is, “Don’t put all your eggs in one basket.” Since it’s not unusual for a sell-off to affect only parts of the market, a diverse portfolio may be able to better ride out a market sell-off than a portfolio that is particularly weighted toward one sector, industry or exchange.

Some investors may diversify with a range of assets in their portfolio. Others may diversify their portfolio with a range of domestic and international stocks. And others may see diversification as a way to invest beyond the market, such as investing directly in real estate, art or other different types of investments that are independent of market movement.

Another way some investors ensure diversification within their portfolio is to focus the majority of their portfolio on ETFs and mutual funds, instead of individual stocks. ETFs and mutual funds can contain hundreds or even thousands of securities across asset classes, which can potentially make the fund less vulnerable to market dips.

Protecting a Portfolio From Sell-Offs

In addition to building a portfolio that’s less vulnerable to market volatility, investors have several options to further protect their portfolio. These preventative investment measures can remove emotion during a market dip or sell-off so that an investor knows that there are stopgaps and safeguards for their portfolio.

Stop Losses

This is an automatic trade order that investors can set up so that shares of a certain stock are automatically traded or sold when they hit a price predetermined by an investor. This can protect an investment for an individual stock or for an overall market drop. There are several stop-loss order variants, including a hard stop (the trade will execute when the stock reaches a set price) and a trailing stop (the price to trade changes as the price of the stock increases).

Put Options

Put options are another type of order that allows investors to sell at a set price during a certain time frame, “holding” the price if the stock drops lower and allowing the investor to sell at the higher price even if the stock drops further.

Limit Orders

Investors can also set limit orders. These allow an investor to choose the price and number of shares they wish to buy of a certain stock. The trade will only execute if the stock hits the set price. This allows investors freedom from tracking numbers as price points shift.

The Takeaway

A market sell-off is triggered when a large group of investors sells their stocks at once, causing stock prices to drop. A sell-off can be caused by world events, industry changes, or even corporate news.

There is no one smart way to react to a sell-off. Different investors will gravitate toward different strategies. But by researching companies and setting up a portfolio based on risk tolerance, an investor can feel confident that their portfolio can withstand market volatility.

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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

Image Credit: Andrii Yalanskyi // iStock

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