Markets can be rollercoasters, and while the S&P 500 is up 10.4% year to date as of May 29, not all sectors or individual stocks are reflecting this upward trend.
For example, the S&P 500 real estate sector is down 8.5% this year due to high interest rates, persistent declines in commercial real estate prices, and declining occupancy rates, while the consumer discretionary sector is roughly flat, driven primarily by Tesla Inc. (ticker: TSLA), down roughly 29% year to date.
Losses could be even greater for investors who went beyond the broad indexes and made more speculative bets. Take the example of investors who jumped on the meme stock bandwagon of AMC Entertainment (AMC) and GameStop (GME) during the February 2021 mania.
Since then, both meme stocks have plummeted, with annualized losses of 69.1% and 45.8%, respectively. After numerous dilutions, disappointing earnings and reverse splits, $10,000 invested in AMC or GME at their peak would be worth just $221 and $1,365, respectively, today.
While some investors advocate holding on to declining stocks no matter what (a practice known as “diamond handling” on forums such as WallStreetBets), it’s important to consider whether holding on to such investments aligns with your financial goals and risk tolerance.
“Keep in mind that unrealized losses are a natural part of investing, but a sound investment framework emphasizes diversification, so a decline in one stock shouldn’t wipe out your entire portfolio,” says Michael Ashley Shulman, partner and chief investment officer at Running Point Capital Advisors. “Reevaluate your positions, but don’t forget the importance of diversifying your risk.”
Here are some expert insights on how to recover from losses in the stock market.
“Unrealized losses hurt, but for long-term investors, the decision to hold or sell shouldn’t be driven by short-term sentiment,” Shulman said. “The focus should be on the long-term prospects for the company or industry and whether the fundamentals still support the original investment thesis.”
To effectively manage losses, investors need to pinpoint why their company’s stock price has fallen and evaluate whether that reason will lead to long-term negative consequences.
Fundamental red flags that may justify a sale include serious issues such as accounting scandals, dividend cuts, plummeting operating margins, impairment of the company’s key assets, etc. Additionally, management actions that harm shareholder value, such as ongoing equity dilution, multiple reverse stock splits, or harmful convertible bond issuances, may also justify a sale.
“It can be emotionally tough to cut losses, but investors shouldn’t be afraid to hit the exit button if a stock’s fundamentals weaken,” Shulman says. “Think of your portfolio like an airplane: Sometimes you need to shed weight to weather the storm and get to your destination.”
The key is to not get attached to any particular company and to not treat investing like a team sport. While it can be encouraging to get support from like-minded investors through online communities, this can also reinforce the groupthink that perpetuates the sunk cost fallacy.
“The sunk cost fallacy occurs because investors who are faced with losses tend to become risk-seeking rather than risk-averse,” says John Burkhart, founder and CEO of Capita Solutions, which specializes in the business applications of neuroscience, behavioral economics and data analytics. “Investors will therefore jump at any opportunity to avoid the pain, even if it means incurring larger losses.”
This is seen in investors who “average down” by repeatedly investing in falling stocks in the hope that the price will rise so that they can eventually sell for zero profit. While this is possible, experts warn that it’s not a good idea and is like “catching a falling knife.”
“When you pick a stock, you feel like you own it, and therefore it takes a lot more money to get rid of it,” Burkhart explains. This behavioral bias can lead investors to become myopically focused on stock prices and not honestly evaluate their fundamentals.
Schuman agreed with Burkhart, saying, “I’ve seen people hold on to losing positions for years, holding out hope that they’ll eventually come out right, but this is rarely a winning strategy. In other words, you don’t have to eat the whole apple to know it’s rotten.”
On the other hand, say you hold a quality asset, like shares in Warren Buffett’s conglomerate Berkshire Hathaway Inc. (BRK.A, BRK.B), which boasts double-digit operating margins, a strong return on equity, a diversified portfolio of public and private stocks, and more than $180 billion in cash.
Despite these quality metrics, investors holding BRK.B saw their investment fall by 19.3% during the worst of the COVID-19 crash in March 2020.
In hindsight, it’s clear that this unrealized loss had absolutely nothing to do with a deterioration in BRK.B’s fundamentals – the company was still generating a lot of cash and there were no particular negative factors. So what caused this?
The culprit was market risk, or systematic risk, a type of risk that affects the entire market and is essentially unavoidable. This form of risk is tied to factors that affect a wide range of financial markets, such as economic shifts, geopolitical events, or global financial crises.
It is essentially the volatility that investors must accept when investing in the stock market, which cannot be diversified away and is the fundamental driver of the expected return of any investment above the risk-free rate.
With a five-year monthly beta of 0.89, investors can expect BRK.B to move roughly in tandem with the broader market and to crash when the market does. However, this doesn’t mean BRK.B suddenly became a bad investment and should have been sold off at unrealized losses during the COVID-19 pandemic.
The bottom line? If you have honestly and objectively evaluated your holdings and determined they are good companies, it pays to stay the course even if the market churns and you incur unrealized losses. During this time, you can stay positive by diligently reinvesting your dividends or dollar-cost averaging.
“By continuing to reinvest your dividends when markets are down, you can buy at a lower price and therefore more shares of a particular security,” says Lauren Weibar, senior wealth advisor at Vanguard. “Dropping markets also provide a great opportunity to increase your contributions while prices are low or set up automatic contributions to buy at a different price.”
Alternatively, reducing stress by taking a hands-off approach — ignoring financial news and avoiding checking your portfolio — may be beneficial, especially when the sky feels like it’s falling.
“It’s important to remember that market downturns are not uncommon events and most people will experience at least a few in their lifetimes,” says Nilay Gandhi, senior wealth advisor at Vanguard. “While bear markets can be painful, bull market rallies over the past few years have been more dramatic and often longer-lasting, benefiting investors in the long term.”
Finally, this decision becomes even easier if you own a diversified fund that tracks an index like the S&P 500. With this approach, your long-term investment thesis depends not on any particular company or sector doing well, but on the overall U.S. stock market continuing to grow over the long term. By avoiding panic selling, you can maximize your chances of an inevitable recovery.
“Being in the market for the long term is better than trying to time the market,” said Robert Johnson, a finance professor at Creighton University’s Heider School of Business. “If you missed the top 10 best days in the stock market over the 20-year period from Jan. 2, 2001 to Dec. 31, 2020, you would have lost more than the overall [annualized] The yield was cut from 7.47% to 3.35%.”
There’s another strategic way you can reduce your future tax burden: by harvesting tax losses. “Tax loss harvesting can be a silver lining during times of market turmoil,” says Wyber. “While investors can’t control the inevitable ups and downs of the market, they can control when they lock in losses within their portfolios.”
You can use tax loss recapture to offset capital gains or deduct up to $3,000 from your ordinary income for the year if your losses exceed your gains. Plus, if you have any losses remaining, you can carry them forward indefinitely to use at a later date when you can realize a larger capital gain.
However, there are subtleties to consider. First, short-term and long-term capital losses must first be applied to short-term and long-term capital gains, respectively. Second, wash sale rules mean you can’t sell an investment to claim a loss and then immediately repurchase that investment or another “substantially identical” investment to continue investing. You must wait 30 days or choose a different asset.
But there is a legal way around this: “If you want to stay invested, sell at a loss and use the proceeds to buy a similar, but not substantially identical, fund,” says Weiber. “That way you can recoup your losses and capture upside when the market recovers.”
For example, if you sell Mastercard Inc. (MA) at a loss, you can quickly buy its competitor, Visa Inc. (V), to maintain exposure to the credit card industry duopoly.
This tactic is even more versatile for fund investors, as many funds have similar risk and return profiles but are not substantially identical because they have different underlying benchmarks.
For example, the Vanguard S&P 500 ETF (VOO) and Vanguard Total Stock Market ETF (VTI) have similar historical 10-year performance, 12.4% and 11.8% annualized, and they have similar top holdings.
But because they track different benchmarks, the S&P 500 and CRSP US Total Market Index, respectively, investors can sell VOO for less than their cost basis, claim a tax loss, and immediately invest the proceeds in VTI to stay invested.
Keep in mind that only taxable brokerage accounts can recoup losses: “This is a way to get out of a tight spot, but it doesn’t apply if losses occurred in tax-exempt or tax-deferred accounts like IRAs, Roth IRAs or 401(k)s,” Shulman explains.
