Catherine Brock

The Motley Fool

Philosopher Daniel Dennett said, "As every scuba diver knows, panic is your worst enemy: When it hits, your mind starts to thrash, and you are likely to do something really stupid and self-destructive." His conclusion is not exclusive to scuba diving – and is particularly relevant in the current stock market environment.

On Feb. 12, the Dow Jones Industrial Average closed at 29,551. A month later, the blue-chip index has dipped below 22,000 – a drop of about 25%. Fueled by coronavirus fears and uncertainty around oil prices, investors dumped their holdings to limit losses.

As a 401(k) investor, you might be tempted to follow suit. Or maybe you already have. Either way, you should know these three consequences of selling in a panic.

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1. You realize losses

Even in stable market conditions, the value of your investments fluctuates daily. If you're like most 401(k) investors, you don't react until the change is negative and large enough to make you uncomfortable. From that moment forward, it feels like someone is actively taking money away from you.

When you feel the urge to sell, remember that any sales transaction requires both parties to agree on a fair price. You've experienced this if you've ever turned down a lowball offer on a home or car. The same concept is true in your 401(k). When the market is in a downturn, all offers are lowball offers. And they're not meaningful unless you agree that your investments are worth less than you paid for them. If you believe the market will recover and you have time to wait it out, you don't have to accept the lowball offer.

In reality, there's only one day when it truly matters what your investments are worth, and that's the day you sell. Selling converts your investments to cash and locks in any value changes. The cash might feel safer, because it won't lose, say, 10% of its value overnight – but it won't gain 10% either, or earn any dividends.

2. You have to time the market to catch the upswing

Selling your 401(k) investments gives you another responsibility, and that's deciding when to get back into the market. That's no easy task, even for the professionals. By the time the market demonstrates a stable pattern of positive performance, you've probably missed out on the biggest recovery gains. You might even jump in just in time to experience another stock market correction.

If that sounds overly dramatic, consider the Dow's performance from 2000 to 2005, as shown in the data below, obtained via Yahoo Finance.

2000 Dow average gain or loss: -4.84%

2001 Dow average gain or loss: -5.52%

2002 Dow average gain or loss: -15.10%

2003 Dow average gain or loss: +28%

2004 Dow average gain or loss: +5.12%

2005 Dow average gain or loss: +1.54%

You can see how being late on the recovery can cost you. From 2000 to 2002, the Dow had three consecutive years of declines, followed by a huge gain in 2003. The gains in 2004 and 2005 were much lower. Had you missed all or part of the 28% run-up in 2003, you might still be sitting on losses at the end of 2005.

3. You risk paying fees

There are two types of fees that mutual funds can charge when you sell shares: early redemption fees and deferred sales charges. Check with your fund to see if either of these apply to you.

Early redemption fees are in place to discourage you from short-term trading. Not all mutual funds have them, but those that do specify a minimum holding period that ranges from 30 days to one year. Sell before that minimum duration and you get charged the fee, which could be a stated dollar amount or a percentage of the value of shares sold.

Deferred sales charges on mutual funds are called back-end loads. These fees are collected specifically to pay a commission to the broker. Typically, the fee goes down over time, dropping to zero if you hold the fund long enough. The holding period required to eliminate the sales charge is defined by the fund, but it can be as long as six years. You'll see deferred sales charges on Class B shares.

Play the long game instead

Over the past 25 years, the Dow Jones has grown at an average annual rate of 7.55%. That includes the 31.99% decline in 2008, the 25.09% gain in 2019, and all the ups and downs in between. When you move in and out of the market based on short-term trends, there's no telling how your long-term performance could shake out.

Yes, you might be a genius at timing the market to avoid the worst losses and to capture the highest gains. But it's more likely that you'd miss out on part of the upswing after a correction. Losing out on one big gain would dramatically reduce your overall, long-term average annual return. Ultimately, that's the real risk you take when you panic and sell your 401(k) investments.

As long as you don't need the cash right away, take a deep breath and ride out the turbulence. The market always recovers, and you're best positioned to benefit from that when you stay invested.

Catherine Brock has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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