Many investors are concerned about a stock market correction at a time when the S&P 500 and Nasdaq they are at or near the highest level, despite 6.7% unemployment and an additional 6.7 million Americans employed only part-time for economic reasons. If the market crashes, trillions in equity will be wiped out overnight, and the prospect of losing up to 10% to 20% of your retirement portfolio is certainly distressing. However, investors should also take into account the possibility that the market will continue to grow for several years.
Overreacting, behaving emotionally and being guided by fear are often disaster recipes for investors. The best long-term results are achieved by adhering to the established portfolio allocation principles and staying with them, even in difficult periods. Small adjustments can be made based on changing conditions, but it is bad practice to deviate too far from the plan. Consider these three ways to be responsibly prepared for a possible market downturn.
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1. Have cash reserves
Money in the bank is liquid and available, but people generally hate the idea of sacrificing the growth that these assets could produce as investments. Investors must make sure that they have sufficient cash available and are protected from volatility to cover expenses, but not to the point of missing opportunities for growth.
Financial planners generally recommend having cash reserves of any amount from three months of expenditure to six months of income. The exact amount depends on you, but this is a reasonable range, depending on the needs of your home. For workers, the stock market crash usually coincides with rising unemployment or tough times for small businesses, both of which can take several months to overcome for most families. For retirees, it can be disastrous to withdraw assets from a falling investment account. If your cash reserves are very low, it is advisable to move some capital market assets to an accessible, non-volatile bank account.
2. Make sure your investment allocation reflects risk tolerance
Investment allocation must always be in line with risk tolerance, but this is especially important when the market tends to fall. Risk tolerance questionnaires are useful tools for determining how much of your portfolio should be in stocks versus bonds, based on how you will perceive losses and gains.
The time horizon is a related determinant of allocation. Investors who have short- and medium-term cash needs, such as retirees, cannot withstand a market slowdown before withdrawing funds. Investors with long-term horizons, like young people who invest for retirement, can easily overcome temporary bearish markets that will be destroyed by future growth. If you are approaching or retiring, you should have at least 30% of your portfolio in bonds and potentially much more.
If a market crash is on the horizon, now is a great time to ensure that your allocation reflects your risk profile. Do not overexpose yourself to actions, but also do not abandon them completely.
3. Rebalance if necessary
Rebalancing may be necessary at the end of a bull market. High-growth stocks outperformed other asset classes and probably grew to make up a larger percentage of their portfolio than when the allocation was initially created. There is a reason that a balanced portfolio contains certain percentages of different types of shares, and recent momentum does not negate that reason.
The stocks that worked best to drive growth in a bull market may be difficult to sell, but many of them also tend to drag an account around during a crash. Investors learned this lesson the hard way with Internet stocks in the dot-com bubble and financial stocks in the global financial crisis. Investors should not abandon high-growth stocks that have been performing well, but it is advisable to take advantage of some gains and reallocate them to other stocks that have less assumed future success in their pricing. If the market is going to crash, bullish cyclical stocks are more likely to be crushed than stable, low-profile stocks. Investors must maintain a balanced allocation between sectors, industries, geographies and company sizes.