Lesson 9.1 · 1 of 5 · Beginner psychology
What to do when your investment falls: paper losses and your plan
When your investment falls, the loss stays on screen until the moment you sell. In 2020 the S&P 500 fell 33.9% in five weeks and was back at its peak less than five months after the low. A plan written in advance, while you are calm, is what helps most.
Terms in this lesson
- Maximum drawdown
- The largest fall in price from a peak to the lowest point after it.
- Bear market
- A period in which the stock market falls at least 20% from its last peak.
- Volatility
- How much the price usually goes up and down in a year.
- Correction
- A drop of 10-20% from a recent peak.
Opening question
You put $10,000 into an S&P 500 ETF. Your account now shows $7,500. What has happened to your money?
You still own the same units of the ETF; they are just worth less today. Sell now and the $2,500 becomes a realised loss. Hold on and the value may recover, or fall further.
It does not matter if you get it wrong: trying first helps you remember.
Why a fall hurts so much
Definition
What is loss aversion?
A loss hurts about twice as much as an equal gain pleases us.
That is what the psychologists Daniel Kahneman and Amos Tversky found: in 1992 they estimated that a loss “weighs” around 2.25 times as much as a gain of the same size. So a $1,000 fall ruins our day more than a $1,000 rise makes it, and the urge to stop the pain pushes us to sell.
Myth or fact?
“If my investment has fallen 30%, it only needs to rise 30% to get back to where I started.”
Myth. Going from $10,000 to $7,000 is a 30% loss. To get back to $10,000 you need a 42.9% rise, because you are now starting from a smaller sum. The bigger the fall, the more the recovery has to make up.
Paper losses versus real losses
- Low: -33.9%
Five closing levels of the S&P 500 in 2020: 3,386 on 19 February, 2,237 on 23 March, 2,912 on 30 April, 3,232 on 8 June and 3,390 on 18 August, just above the February peak.
Anna sells on 23 March$10,000 becomes $6,608
- No more falls on the screen
- The $3,392 loss becomes permanent
- She misses the recovery that followed
Ben holds onback to $10,011 on 18 August
- Recovers the whole fall
- Keeps the dividends paid in the meantime
- Lives through five very hard weeks
Work it out
You have $10,000 in an S&P 500 ETF on 19 February 2020. The index falls 33.9% by 23 March. Roughly how many dollars is your investment worth then?
A hint
Take 33.9% off $10,000.
$10,000 × (1 - 0.339) = $6,610. On screen, $3,390 is missing. It only becomes a realised loss for someone who sells at that point.
Check yourself
What turns a fall on screen into a real loss?
This exercise is in the free account, where we also save your progress.
Create a free accountA plan for the bad days
- 1Write down why you bought and for how many years. A long-term reason doesn’t change in one bad week.
- 2Keep an emergency fund, so you are never forced to sell during a fall because you need cash.
- 3Decide in advance what you will do at -20% or -30%: nothing, rebalance, or carry on with your usual monthly amount.
- 4Look at your account once a month, not ten times a day.
Check yourself
When is the best time to make your plan for a market fall?
This exercise is in the free account, where we also save your progress.
Create a free accountWhat would you do?
It is 23 March 2020. Your S&P 500 ETF has lost a third in five weeks and the news talks of an unprecedented crisis. What do you do?
This exercise is in the free account, where we also save your progress.
Create a free accountWhat you learned
- A fall only becomes a realised loss when you sell; until then it is on screen.
- After a fall of X%, you need more than X% to recover: from -30% you need +42.9%.
- A plan written while you are calm stops fear making the decisions on bad days.
You reached the end
Keep what you learned
With a free account we remember your lessons, bring back the questions you got wrong exactly when you need them and keep your streak.
Save your progress with a free accountLessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: S&P 500 closes in 2020 of 3,386.15 (19 February), 2,237.40 (23 March), 2,912.43 (30 April), 3,232.39 (8 June) and 3,389.78 (18 August), from Associated Press, CNBC and Yahoo Finance; the March 2013 recovery, from NPR; Tversky and Kahneman, “Advances in Prospect Theory” (1992). The chart joins only these five closes.