How Should Investors React When the Market Drops 5% or More?
Key Points
Declines of 5% in the S&P 500 have occurred almost every year over the past half century. Volatility is normal.
Investors often over-trade when stock prices decline. This is a case where doing less is usually better.
There are three things you should consider doing instead if fear starts setting in.
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Earlier this year, investors got a reminder that stock prices don't always go straight up. The Iran war caused the S&P 500 (SNPINDEX: ^GSPC) to decline by 9% in March. The equity market has since recovered those losses, but it was a jolt that many investors didn't expect after a year of steadily rising stock prices.
Unfortunately, my fears when a situation like this plays out came true -- people ran for the exits. The Vanguard S&P 500 ETF (NYSEMKT: VOO) saw a net outflow of $11 billion in March, only the second negative month in more than three years. Granted, it's only one ETF but this one tends to be a pretty good proxy for overall investor sentiment and behavior.
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Studies have consistently shown that investors don't earn nearly the same returns as the underlying indices due to mistimed trading. Some of those gaps can be significant.
| Year | S&P 500 Return | Average Investor Return |
|---|---|---|
| 2022 | (18.11%) | (21.17%) |
| 2023 | 26.29% | 20.79% |
| 2024 | 25.05% | 16.54% |
| 2025 | 17.88% | 17.16% |
Data source: DALBAR.
It's too early to assess this year's damage, but the swift decline and rapid recovery is exactly the type of environment where investors tend to do the worst. The rebound happens before they have a chance to react or are comfortable getting back in. So what should investors do instead? Here are a few ideas for keeping a calm, level head during market pullbacks.
Image source: Getty Images.
Do nothing
The best thing you can do is probably just ignore it. If your goals, timeline, and risk tolerance haven't changed, there's really no good reason to sell, especially for a small 5% down move. Here are some facts from Fidelity regarding the frequency of corrections:
- From 1980 to 2025, only three years didn't see a decline of 5%. These kinds of pullbacks are entirely normal. Investors shouldn't overreact to them.
- Roughly half of the years saw a decline of 10% or more. It may not feel like it based on recent history, but corrections are relatively frequent too.
- Since 1980, the S&P 500 has experienced an average intra-year decline of around 14%.
Stock market volatility is normal and should be expected.
Revisit your risk tolerance
Most investors are fine with risk when stock prices are going higher. It's when things start heading south that you find out what someone's true risk tolerance is.
The problem with having a portfolio allocation more aggressive than you're comfortable with is the results table above. Emotional trading often involves selling after stocks have gone down and only returning once they've gone back up. The end result is that you miss out on the rebound and ultimately damage your investment performance.
Consider an allocation that's designed to limit some of the ups and downs that are worrying you. Bonds, of course, are great for this. You can still find 3-4% yields in risk-free Treasury bills and money market funds. If you pair those up with an equity allocation that focuses on more defensive, value, or dividend stocks, you could end up with a portfolio that works better for your nerves.
Consider buying the dip
While a lot of people look for the exits when stock prices start falling, maybe you should be looking for the entrance.
These could be opportunities to buy stocks whose prices are temporarily depressed, letting you essential buying them on sale. If you think that the Iran war, for example, is only temporary, March could have been an ideal time to buy the dip. By buying lower, you take away some of the downside risk and give yourself a chance to catch the rebound as well.
No asset allocation should be such that it prevents you from sleeping at night. Often, a couple of simple changes can make the journey easier.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
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