What To Do When The Stock Market Drops

Just in case you've been reading any of the ominous predictions about our lazy "bull" market or about the panic in China's market, I thought it was a good time to talk about when you should be making changes in your investment account. The short answer to "what should I do when the market drops" is easy—not much. But there are some reasons to do some trading in your account. Here are some things that go wrong in investment accounts—and how often you should check on your accounts to fix them:

1. Lazy cash. You've set up your investment accounts, bought your first stocks or funds and started adding regularly to your account. Great! But if you don't make some kind of arrangement for your new deposits to get invested, all of that money you are adding to the account might as well be stuffed under your mattress. If possible, automate your account to invest new deposits and check quarterly. Otherwise schedule a review monthly or quarterly (depending on how much you are adding) to invest the new cash;
2. Out-of-Whack Allocations. You've created a fantastic portfolio model for your investments and bought all the right percentages of large cap stocks, bonds, small cap stocks, etc..., and now you can sit back and let it work. Except that, as it works, some of your assets will be doing better than others. Over time, this means that one of or two of your asset classes will be growing larger and faster than others. At some point, you will need to rebalance. Notice that this mean buying the kinds of investment that did worse in the market. This is not a mistake—markets frequently cycle so that the investment on the bottom this year is likely to be on top a year or two from now. Check a minimum of once a year up to four times a year to be sure that you are still within range of the portfolio model you originally designed;
3. Change of plans. Sometimes it's your plans that change; other times, it will be a fund manager or company. If you are invested directly in stocks, this may be a case of your chosen small-cap company being bought out by a large multinational. If you are in funds, you may find that the original investment objectives of the fund has changed from investing in a good mix of stocks and bonds to primarily bonds (if you were counting on this fund for your bond allocation, you need to come up with a substitute). At your once a year check, take a look at the investments in your account ("positions") AND click on the name of funds to review their holdings.

And here is the #1 reason not to make changes in your investment account: stock market headlines. Why? Because you came up with a plan for how you want to manage your investments, and if that plan did not account for the ups and downs of every stock market, then it really wasn't a plan to begin with. Don't get thrown off by people trying to create more readers.

How To Rebalance Your Portfolio

If you have diversified your investments and come up with an allocation model, you know how you want your portfolio to look. Over time, though, some investments do better than others. Eventually, those stocks that were supposed to be 15% of your portfolio will end up closer to 20%. So what are the best tips for rebalancing when that happens? First, if you are regularly adding to your account, a patient strategy of shifting how you invest new money is your best approach. Each time you add money to your account, invest the new cash in one of the asset classes that is below your targets. One deposit may be enough, or you may need to continue adding to the below-target class for several months.  When that class is on target, switch your investing to another below-target class. Take your time; the balance does not have to be perfect so long as you are moving in the right direction.

If you are not regularly adding to your account, you will need to sell some of your holdings from an above-target asset to buy into the asset class that is below your target.

Notice that both approaches mean selling or passing on shares of your best performing stock or fund—the one you've been thrilled with—in order to invest more in the dud that's been disappointing you. It might feel like a mistake, but this effect is part of what makes asset allocation work. You will find that following your plan helps you avoid the trap of buying the stuff that has already peaked and forces you to purchase the low-performing investments before they start their own rise in market cycle.