How to prepare for a downturn (est read time: 4 mins)

Dan Kemp, Chief Investment Officer, EMEA 

Ryan Murphy, Head of Decision Sciences, Americas

Key Takeaways

Market downturns are inevitable. Expect them, lean into them, embrace good habits. The good news is you don’t have to do anything different in a downturn than at any other period in investing. But if signs are pointing towards a downturn, it’s a great time to be reminded of good investing habits, including:

• Looking beyond the immediate horizon. Having a long-term view is usually rewarded.
• Embracing the chance to buy lower-priced assets.
• Disabling electronic notifications of investment prices and portfolio returns. This will help you stay focused on your financial goals rather than the latest market noise.
• Making regular contributions and setting up a plan to ‘save more later’.

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

Peter Lynch[1]

The power of a downturn

First, let’s consider what we mean by ‘downturn’. We’re talking about periodic sell-offs, often associated with uncertainty or negative surprises, with varying degrees of severity. Take, for example, the global financial crisis of 2007-09, one of the worst downturns in modern history, as well as the relatively minor 10% market reversals that happen every few years. Together, these losses mean that investors are likely to face multiple downturns in their lifetimes.  

So, what steps can investors take to mitigate the emotional impact of a downturn?

Remember the cost of trying to time the market

Downturns can incite an urge to sell, leading investors to sit in cash for a while before getting back into stocks when it feels like the danger of further loss has passed. Not only is this a bad habit (market timing is notoriously difficult and is known to exacerbate the ‘investor gap’[1]), but it also carries a low probability of success. Cash rates can struggle to keep up with inflation over the long term, which means your efforts to preserve capital may erode your savings.

Action versus inaction: If you are investing for long-term wealth attainment, remember the probabilities support staying invested. Markets have a long history of rebounding, so you’re likely better off waiting patiently rather than trying to trade in and out of different investments. If you setup your investments some time ago, it’s worthwhile checking that everything is still appropriate for your goals, but generally our analysis has shown that ‘time in’ the market offers more reliable returns than ‘timing’ the market.

[1] Peter Lynch via Worth Magazine 1992 – 1999

[2] The ‘investor gap’ is a measure of what investors actually receive (assessed using asset flow-adjusted returns) versus what they ought to have received if they simply bought and held.  

Understand how loss aversion can drive good decisions  

Losses heighten the desire to act, but it’s important to remember that the best things to do in the wake of a drawdown are much the same as at any other time. Building good saving habits is perhaps the most important step to take at any time. Investors should be saving regularly, especially towards their longest-term goals, such as retirement accounts, regardless of the stage in the market cycle. There’s also the ‘save more later’ technique, where you might commit (through an automated system or otherwise) to saving 3% of your salary one year, 4% the next year, 5% the year after, and so on. These small increases are an emotionless nudge that makes saving a habit.

Action versus inaction: The threat of losses can alter how investors perceive the value and relative effort of investing, including whether it’s worth pushing through the troughs to access the peaks. But this is where discipline can really help an investor: If it is a long-term goal, such as funding your retirement, stay the course and keep saving regularly. Investors who do this have an advantage—they are keeping their emotions at arm’s length, helping ‘bucket’ goals and disassociating market volatility from wealth attainment. This can act as a strong reminder of why investors should stay invested, while mitigating some of the concern that comes from periodic downturns.

Beware of technology traps

Though many fintech developments have made investing easier, some can add a layer of emotional stress. Receiving notifications every time trades are made, and money is gained or lost, can be a very effective way of tracking how a portfolio’s moving. But the constant pinging can foster anxiety around investments, potentially leading to panicked moves when markets sell off.

Action versus inaction: As Nobel Prize winner Richard Thaler said, “First, never underestimate the power of inertia. Second, that power can be harnessed.” This advice can be applied effectively here, nudging investors to check in on their portfolios less, resulting in fewer discoveries (and the subsequent emotional shock) of loss. Ideally, developing this habit early in a person’s investing career, or between periodic downturns where possible, should hold you in good stead when markets become tougher. Out of sight, (somewhat) out of mind.

Lean into the drags

Let’s face the facts—downturns can cause a significant drag on your wealth and your psychology. If an investment falls by 50%, it needs to rise by 100% to get back to the same level. Similarly, we feel losses approximately twice as much as we feel same-sized gains.

Techniques like diversification can offer a cushioning effect in both long-term recessions and shorter crashes. But rather than relying on diversification alone, we’ll refer you to one of our investment principles: that investment should be valuation-driven. Troughs in the market often lead to underpriced assets, which is where we (and some of the investing greats like Warren Buffett) believe that the best value is found. Rigorous fundamental analysis allows us to examine the full value of an asset, rather than simply its price, which some mistake for an indicator of quality. Thus, we see downturns as an opportunity to buy assets with strong fundamentals that can potentially deliver good long-term returns at lower entry prices.

Action versus inaction: Embrace the importance of being a willing buyer, not a pressured seller, after a market decline. Keeping a long-term view is key. While prices move constantly, most successful investments are built on patience as good quality companies often grow through recessions, but their true value is not appreciated until later. It’s for this reason that Morningstar Investment Management values patience and the ability to think independently as being the key characteristics of a successful investor. 

Predictions hinder, not help

Last, we want to shed light on the recency bias—a common pitfall—which works on the assumption that because a trend or movement has happened in the recent past, it’ll continue into the future. This challenge may well be heightened during downturns, with long periods of lagging returns causing investors to second-guess their strategies.

Action versus inaction: If you find yourself focusing on recent returns, ensure you spend some time studying longer-term returns and periods of recovery. This search for dispelling evidence can help offset the gloom we tend to feel in a downturn. Remember, consistency is what matters. Buying and holding means you’ll experience both the best days and the worst days. 

Since its original publication, this piece may have been edited to reflect the regulatory requirements of regions outside of the country it was originally published in.

This Report has been issued and distributed in Australia by Morningstar Investment Management Australia Ltd (ABN: 54 071 808 501; ASFL: 228986) which is regulated by the Australian Securities and Investments Commission. Morningstar Investment Management Australia Ltd is the provider of the general advice and takes responsibility for the production of this report. To the extent the Report contains general advice it has been prepared without reference to an investor’s objectives, financial situation or needs. Investors should consider the advice in light of these matters and, if applicable, the relevant Product Disclosure Statement before making any decision to invest.   Refer to our Financial Services Guide (FSG) for more information at https://morningstarinvestments.com.au/fsg.