What to Do When the Stock Market Plummets

Bull and bear market
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If you had invested into the stock market in December 2012, and then were sprinkled with fairy dust, falling into a Rip Van Winkle-esque slumber until Jan. 1, 2014, upon awakening, not only would you have been well-rested, you'd also have been thrilled to find your portfolio up 34 percent.

Unfortunately, that's not how it works in the real world. As investors, we experience the daily market moves in real-time, including all the drops and pullbacks that happen along the way. Sometimes those moves can be severe, and how you react to them can dramatically affect your portfolio's overall performance.

So when the market drops hard -- as it has done this month -- what can you do to minimize the damage and optimize your performance?

Don't Believe the Hype

When the market experiences a series of steep down days, you'll find a lot of people coming out of the woodwork, running around and screaming "The sky is falling!" Some will warn that this is "the big one," when the market finally crashes, destroying the capitalist system as we know it, and plunging us back into a financial stone age where only gold, fish oil, and canned peaches will have any value.

Don't believe them. Especially if the people saying it are part of the financial media.

Every strong bull market experiences pullbacks, sometimes rapid and severe ones. It's not only normal, but healthy, for bull markets to pull back between 10 percent and 15 percent at times. A market isn't even considered to be in "bear" territory until it drops more than 20 percent.

The financial media doesn't care about that. Their job is not to help you manage your investments, and it's certainly not to make you money. Their job is to get as many people as they can to watch their videos, read their articles (and view their advertisers' ads), which they accomplish by shouting doomsday warnings, hoping to play on your fears and emotions so that you'll pay attention to them.

Don't.

With all apologies to Timothy Leary, turn them off and tune them out. Reducing the noise generated by financial pundits will clear your head and prepare you for the next step.

Time for Some Prudent Pruning

Next, it's time to go through your portfolio and trim your losers -- stocks that you might've initially picked up into based on sound analysis, but that for some reason just haven't panned out. Getting rid of underperforming stocks when the market starts to pull back makes sense on a number of different levels.

Stocks that lag during strong markets will generally perform the worst during market corrections, so keeping them in your portfolio can drastically drag down your overall returns. They also tie up capital you'll need in order to invest in the next round of winning stocks.

Don't get emotional about it; just cut them loose and move on.

Get Your Shopping List Out

Now that you recognized the capitalism isn't imploding and you've freed up some cash by selling your losing stocks, it's time to make a shopping list of the stocks you want to buy. These might be strong performers that you missed previously, ones you've been waiting to pick up at a discount. But before you buy them, you want to make sure they still have the potential to outperform the market.

You do this by looking at the relative strength of the individual stocks that interest you. No stock is immune when the broad market corrects -- almost all of them will lose some value -- but what you want to look for are the stocks that lose less value compared to the overall market.

So when the market is working its way lower, look for the stocks that drop fewer percentage points. If the average loss for stocks during a correction is 12 percent, but you find that XYZ only dropped 6 percent, then it's outperformed the market on a relative basis. This is a sign that investors, often institutional investors, are unwilling to sell the stock because of their perception of its underlying value.

And stocks that hold up best during selloffs are usually the biggest winners when the market turns around.

So pay no mind to what the Chicken Littles of the market do and say when a normal correction comes. Instead, just follow these three simple steps, and you'll be surprised how much your returns improve over time.

No man is an island, or even a peninsula, so I encourage your feedback in the comments below. I also want to hear what else you'd like me to write about, so please let me know by connecting with me on Twitter.

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