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Non-emotional actions you can take.
The equity markets have again pushed against all-time highs. During these times, sentiment amongst investors is often split. Some believe the markets will continue to push higher and continue to buy into the euphoria of the markets rising. Others believe the markets are due for a correction and start pulling out of investments to preserve their profits. This is an action driven by fear. Whether putting more money into the markets with the belief they will continue rising in the short term or pulling money off the table in anticipation of an impending drop, both actions are emotional responses to feelings of euphoria and fear. Investing with emotion can lead to costly mistakes.
When markets are approaching and sometimes exceeding all-time highs, and there is uncertainty about whether they will head higher or lower, what are some non-emotional actions you can take?
Having an investment strategy is critical. Staying disciplined during market uncertainty is key to long-term investment success, and your investment strategy is there to protect you from reacting emotionally and making mistakes. The strategy will tell you when to buy, what types of investments to buy, and the circumstances in which it is acceptable to sell. Having this investment strategy will allow you to focus on growing your wealth in a disciplined and planned out manner, while also ignoring the outside noise.
The markets are often cyclical, and while one asset class may be doing well, another may be struggling. This can lead to your asset classes straying from their target percentages. Some categories may become overweighted and others underweighted. One of the keys to long-term investing is keeping your asset allocation in line with its target percentages. If some categories are over or under weight, then your policy is taking on more risk than originally intended.
There are two preferred methods of rebalancing. Option one is to sell a portion of the category that is overweight and reallocate the proceeds to underweight categories. In tax-advantaged accounts like 401(k)s and IRAs, rebalancing is relatively easy to do because you can sell investments without having to worry about capital gains taxes; however, in taxable accounts like individual, joint, and trust accounts, the tax implications of selling must be factored into the rebalancing decision. You could end up owing a hefty capital gains tax if you rebalance by selling an investment with a significant gain. For taxable accounts, rebalancing strategy option two typically works best: add more money to the account and invest in the underweight categories.
Knowing when the markets will experience a pullback or correction is nearly impossible. However, when the markets head in a negative direction, excellent buying opportunities may arise and some investments may be trading at a discount. You can be prepared to take advantage of these moments by having cash on hand.
Start by determining the amount of cash you want or feel comfortable sitting in reserves. Use this stockpile to invest in categories trading at a discount during market pullbacks. Since it is impossible to know when the market has hit its bottom, use a dollar cost averaging strategy to invest incrementally over a set period. Buying incrementally removes the risk of putting all your chips on the table at one time and have the investments continue to drop. As markets and investment values continue to fall, you will incrementally purchase at more and more advantageous prices. It may not get you quite the return as if you had perfectly picked the bottom of the market pullback, but that is a difficult, if not impossible feat to get right consistently.
No one can really know whether markets will continue climbing or experience a pullback when pushing record highs. Having a plan in place will allow you to stay disciplined and invest without emotion. Remaining well-allocated and diversified across asset classes will reduce the risk in your overall portfolio. Finally, have a little cash available in case some investments are trading at a discount.