Selling and reducing risk is sometimes rational

How does a person rationally manage a portfolio, and in which cases can you think of opting for a risk reduction in a bear market, when the markets go down? 

Usually, interest in handling market crashes increases when a financial meltdown is underway. For many investors, 2022 was the first bear market ever closely observed, or at least the first that threatens to have a lasting impact. This includes government spending and cash injections that quickly neutralized the pandemic-induced meltdown. 

Many small savers have approached the financial markets for the first time, often exposing themselves to high risks, encouraged by the exuberant share price increases following the worst part of the pandemic.

It is necessary to emphasize correct risk planning, which is essential to stay on course when the collapse occurs. Sooner or later — this is the lesson of capitalist history — economic and financial crises occur and act as if otherwise it could be very harmful. 

The bear can break into the markets at any time, and for this reason, it is good that investors know this in advance and have a diversified portfolio in a balanced way and an adequate time horizon. All strategies have pros and cons to bear, including those that seem wise. Entering and exiting the markets only works 100% in hindsight at certain times and the truth is that severe market drops happen from time to time and are part of investing in the stock market. 

When the markets go down, the dominant suggestion is not to act impulsively, selling off one's portfolio and forfeiting the losses. The experience of the past sees those investors who decide to embrace a long-term approach rewarded. But is the decision to sell always an irrational choice? The answer depends on several factors. It should be well understood on what basis the investor previously built his asset allocation and if it was consistent with his risk profile and ability to withstand adverse phases.

In the ideal strategy, even a possible bear market should not put the investor in the position of selling at a loss. Unfortunately, an excess of confidence in the continuous rise of the markets could have encouraged excessive risk-taking but we realize that it is only when the market goes bearish. 

Many market savers are bullish, tend to underestimate the risks and concentrate their investments on the most fashionable topics, such as cryptocurrencies. The first question an investor hit by market downturns should ask is whether his assets have been correctly diversified and whether this asset allocation is ready to face the various market seasons. At that point, some sales could become rational if made in a logic of restructuring or revision or if it is based on a planned and tested strategy of both selling and buying.

Suppose the sale is made on a discretionary or emotional basis. In that case, one exposes oneself to the fact that no one knows what will happen on the markets, and selling everything today to buy again later when everything is calmer will lead, in 90% of cases, the saver to losing the later recovery. 

In a study, a team from the Massachusetts Institute of Technology (MIT) focused on the risks and virtues of "panic selling." It emerged that the main problem of selling in bearish phases is that, in most cases, one returns to the markets too late. 

Research published a few years ago by Schroders highlighted the paradox of an investor who had exited with a 25% loss in the Wall Street crash of 1929. He avoided an additional reduction of 66% of his assets by taking refuge in liquidity. 

Those who had kept the investment in shares despite the storm, after a few decades, would have recovered all the capital while those who had chosen the "prudent" strategy would have taken twice the time to get back to par. 

It is important to put yourself in a position to be able to wait for "the hen tomorrow," as the saying goes. Correcting the shot in the worst phase is not ideal, but it is an eventuality that can arise in the case of excessively risky do-it-yourself planning for personal needs. Despite the ups and downs of the markets, the price of shares and good investments always emerges over time. To invest successfully, being a long-term investor has always paid off.

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