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Make allowances for short-term losses

Whenever volatility hits the financial markets, and short-term losses come into play, it’s easy to think something is seriously wrong. But in fact, nothing is wrong at all! Short-term losses are a natural part of the cycle that is the stock market.

Think about it this way: If the stock market only went up, everyone would be rich, and there would be no need for investment analysis or management. It would be something like earning interest on bank deposits, only the returns would be much richer.

But we know that’s not how the real world works. There’s always a constant tension between risk and reward; the higher the risk, the higher the reward. That’s the entire reason why people invest in stocks in the first place. It’s only because you are embracing a certain amount of risk, that you have the potential to earn double-digit returns on your money.

If there were no risks — and no short-term losses — returns on stocks would be no better than what you can get on fixed-rate assets, such as certificates of deposit in Treasury bills.

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Focus on the years of stock performance

When the market gets choppy, and your portfolio declines, it’s time to develop some necessary perspective. That means focusing on the very long term, as in decades. When viewed from this perspective, the stock market is virtually the best investment available to the average investor.

Just look at the historical record. The stock market has produced average annual returns around 10% since 1928, which is probably longer than you’ve been alive!

Since 1928, there have been all kinds of major declines in the stock market, including the Crash of 1929, the Crash of 1987, the dot.com bust in the early 2000s, and the financial meltdown of 2007-2009. The market has survived all of them, and has continued to provide something approaching 10% average returns despite all of the volatility.

That’s what you need to focus on in the face of short-term losses. It’s well worth it to remember that stocks are a long-term investment, and that your payoff will be achieved over many years, and often decades.

Use market declines to shop for investment bargains

This is a way of taking a positive view of a negative situation. Any time stocks fall in price, it’s a sign to look for bargains. Market declines are an opportunity to buy stocks after they’ve “gone on sale.” The stock that was looking like a strong buy at $50 a share will be an even better investment if the stock drops to $40.

Since you know that stocks will eventually recover — since they always do — buying stocks at bargain prices is a way to double-up your returns when the recovery takes hold. Whatever losses you took as a result of the short-term decline will more than be made up through the increase in price of both your existing stock holdings and any new ones you acquired near the bottom of the market.

When seen in this way, you might even find yourself becoming excited at the prospect of short-term losses. And as a long-term investor, that’s the right attitude to have.

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Don't take rash action

With regard to your existing stock holdings, if the fundamentals of the companies are good, there’s no need to do anything. You certainly don’t need to be selling an otherwise strong company. And once again, if a company that you’re holding at $50 a share suddenly drops to $40, it’s still a good hold — as long as the price decline wasn’t the result of a major reversal by the company itself.

Long-term investing requires self-discipline. This means you should never allow yourself to get into a situation where you will be motivated to panic-sell. If you do, it’s highly likely you will see yourself selling your stocks at the absolute worst time, and then watching them rise in value shortly after.

The worst thing you can do is to sell a stock at $30 that is currently selling at $50, then buy it back six months later at $40, after realizing that you made a mistake when you sold it. If you do something like this, you will have locked in a $10 loss on your stock that will prove to be totally unnecessary.

More: Short selling stocks

Take steps to lower your worry threshold

It is possible that even after realizing that short-term losses are not the threat they sometimes seem to be, you may still be uncomfortable. If that’s the case, then you should take steps in advance that will minimize your fears.

Diversification is probably the single best way to address this problem. It’s possible that at least some of your anxiety stems from the fact that you have too much of your portfolio sitting in equities. If that’s the case, lower your stock holdings and raise your cash position to a point where you feel more comfortable.

For example, if you’re 100% invested in stocks, and the market takes a 20% hit, you will lose 20% of your entire portfolio. But if 20% of your portfolio is held in cash, and stocks represent only 80%, then a 20% drop in stock prices will translate into a total portfolio loss of just 16% (20% X 80%). That won’t completely eliminate the prospect of short-term losses, but it may reduce the severity of those losses to a more tolerable level.

If you understand that short-term losses are neither good nor bad, you’ll have the right mindset to deal with them in a constructive way that will pay off handsomely in the future.

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Kevin Mercadante Freelance Contributor

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com.

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