4 strategies to help you tackle market drops

Investors come in all shapes and sizes, each with different goals, experiences and risk tolerances. But amid the diversity, they all share a common trait: No one enjoys losing money.  

There is a simple solution to avoiding losses on investments, and that's sticking to low-risk assets. This approach isn't entirely risk-free though.  

Cash, for example, is very good at holding its value in the short term, but very bad at increasing in value over the long term.  

Growth assets, such as shares, are bad at holding their value in the short term, while being a proven performer over the long term.  

It makes shares a valuable component of a growth portfolio. The downside is that share values - and by extension, portfolios that include shares - do not grow in a linear fashion. 

This is illustrated in the table below, which shows that Australian shares have delivered positive returns for 29 of the past 38 calendar years. In some years, the results were spectacular, notably 1993 when the market delivered a return of 40.45%.  

Returns of Aussie shares over the past 38 years

Source: ASX All Ordinaries Accumulation Index. 4 January 1988 - 31 December 2024 

While investors find the upswings easy to ride, the downswings are not so palatable. Fortunately, they don't happen very often. Even so, the table above confirms that nine of the past 38 years saw Australian shares end the year in the red.  

A market downturn often sees investors retreat to cash. And stay there. It's the result of 'loss aversion', a cognitive bias that sees the pain of losing money outweigh the pleasure of making a profit.   

While it may be innate, this response costs investors dearly.  

A 2016 study by Boston-based consulting firm DALBAR found that over the preceding 20 years, the US share market delivered annual gains averaging 8.19%. Individual investors earned far less, notching up returns averaging 4.67% annually.  

DALBAR concluded that recovering just a portion of this shortfall would mean "hundreds of billions of dollars earned by investors". The sting in the tail is that the study found investors' own behaviour was "the chief cause of diminished returns". 

Investors have a tendency to pile into equities when the market is performing well (and prices are expensive), and bail out at the first whiff of a downturn (when values are falling). It's an approach that inevitably leads to low returns at best, or racking up losses at worst. 

Strategies to minimise losses 

For investors, the solution is not to avoid the risk of losing money but rather to manage this risk. 

This is particularly pertinent now. Over the past few weeks, President Trump's refusal to rule out a recession and concerns about the impact of the latest tariff threats on the global economy have already resulted in Aussie and US stocks taking a hit. 

A federal election in Australia in a few months and ongoing war and conflict in various global hotspots also all point to the potential for increased volatility ahead. 

Fortunately, a variety of loss mitigation strategies are available to investors. Here are four worth considering to help minimise losses: 

1. Know yourself 

Success as an investor does not hinge on a strong technical understanding of asset markets. Research shows that an individual's emotional ability to accept possible losses plays a key role when it comes to achieving investment objectives.

This makes understanding yourself a critical first step. 

Know how you would cope if the value of your portfolio dipped by 10%, possibly more, in a single day.  

This calls for some serious self-reflection, but it can form the basis of the portfolio that is right for you, your financial goals and your risk tolerance.  

2. Match investments with goals 

Instead of taking an ad hoc approach to investment selection, set some personal goals. Then match your asset allocations to those goals.  

As a simple rule of thumb, short-term goals call for money to be held in cash and fixed income. Longer-term goals can have more weighting towards Australian shares, international shares, property and infrastructure because investors have time to ride out market highs and lows.  

3. Diversify 

There is no better risk mitigation tool than diversification. 

This Nobel Prize-winning strategy, based on spreading a portfolio across asset classes - and also within asset classes - doesn't just lower risk, it reduces volatility. 

The problem is that by their own admission, many Australians are not well-diversified.  

The most recent ASX Investor Study found fewer than half of (44%) on-exchange investors believe they have a diversified portfolio. 

This is an area where exchange-traded funds (ETFs) are a proven game changer. 

ETFs provide a quick, simple, and low-cost way to gain diversification across asset classes and within asset classes. While a traditional fund manager may pick 20 to 30 individual stocks, buying into a single ETF can provide exposure to hundreds of stocks across all markets.   

4. Rebalance - regularly 

Asset allocation is not a set-and-forget task.  

Market movements, coupled with the tendency for investors to hang onto what they perceive to be 'winning' investments, can dramatically alter portfolio risk over time.  

Rebalancing is the process of maintaining portfolio risk in line with an investor's preference.  

As an example, if equity markets fell 10%, a diversified, balanced portfolio with an allocation of 50% cash/bonds and 50% equities, would be underweight equities and overweight cash. The process of rebalancing could involve using cash to buy more equities. This process automatically supports the discipline of buying stocks when they are cheaper, also known as dollar cost averaging. 

The converse holds true. If the sharemarket rose 20% in a year, the portfolio would have higher overall risk. A simple solution to return risk to an investor's comfort level is to sell equities and transfer the funds into cash/bonds. 

It is worth noting that rebalancing doesn't reduce the risk of a market downturn. Rather, it allows an investor to keep their portfolio risk in check.  

How often should you rebalance? Research by Vanguard suggests that rebalancing annually can be ideal, minimising the impact of transaction costs and tax.   

The key takeout 

Investing by its nature involves taking risks.  

Higher risks are rewarded with higher returns, but also the possibility of greater losses.    

What matters is that investors understand the level of risk they are comfortable with, and shape their portfolio accordingly.