One of the things that I often talk about is market corrections. Sometimes I’m asked when I think the next correction will come, but I don’t know that. No one does. What I do know is that corrections are inevitable and that we should always be prepared for one.
Here are four ways you can prepare for the next market correction.
First, How You Should Not Prepare
Preparing for a market correction does not include trying to time the market or predicting the next crash. Neither works in the long run. People try to make market calls all the time, especially at this time of year. Everybody is making their predictions for the new year, and you may find it tempting to listen to them.
However, in the 24 years that I have been in the business, I have found that sometimes people get it right once. Then they get famous, and they try to get it right over and over and over again, but they can’t because no one has a crystal ball. Meanwhile, these “experts” lose credibility because they end up using their fame to peddle something, whether it’s a newsletter, software, or book.
Invest According to Your Risk Tolerance
The first thing you should do to prepare for the next correction is know your risk tolerance and invest that way. One of the keys to financial planning is the risk tolerance questionnaire, which assesses your level of tolerance for investment risk. If you invest based on your risk tolerance, you will avoid emotional mistakes that arise out of fear or greed.
The questionnaire we use to allocate funds takes our clients about 15 minutes to complete. We repeat the questionnaire every two years to make sure our clients’ portfolios still match their tolerance. And we especially like to give them the questionnaire at the bottom and top of a market cycle just to see how much their range changes.
You can take the questionnaire through our home page. Scroll down, and click on “What’s Your Risk Number?” It is a short questionnaire and will give you a basic idea about your investment tolerance.
Have Three Years of Portfolio Draws in Cash
I recommend to clients that they have three years of portfolio draws in cash. Sometimes I get pushback because as soon as a person goes to cash, they are missing out on the dividends and interest that the investments they sold could have earned.
However, when a market correction comes and you sell, you will not get the prices you need for income.
Let’s use an example: The S&P 500 started its major decline for the Great Recession in October 2007 and bottomed in March 2009, a total drop of 56.8%. The market didn’t recover until March 2013—3.8 years later. So you have 3.8 years when, had you been drawing on your portfolio, you would have had less there to recover. Your goal is to be able to survive and even thrive in a market correction, and having three years’ worth of portfolio draws in cash (and enough dividends and interest to make your portfolio last five to seven years) is key.
Diversify Your Portfolio
The other thing that you can do to prepare your portfolio for market declines is balanced and global diversification, especially if you are going into retirement. Most people have a home bias of investing at least 70% of their equity assets in the country that they live in. However, the United States is only 50% or so of the value of the global equity markets—and even lower in terms of overall economic output.
Let’s look at the S&P 500 again: Its major decline started in October 2007, and it did not recover until March 2013. If you had a globally diversified portfolio with at least 15% of your stocks overseas, the maximum drawdown was 34%, instead of the 56.8% that it would have been with the S&P. What’s more, the full recovery would have been three years sooner—in March 2010.
The final step is to make sure you rebalance at least once a year. Say your ideal portfolio is 60% stocks and 40% defensive, and you see in January that the 60% has become 70%. Then you rebalance.
You do this not only on the market’s upside but on the downside as well. If the market is down 10%, you rebalance. If it goes down another 10%, you rebalance. You end up taking advantage of opportunity by buying twice at the lows.
In addition, do not over-weight your portfolio because one sector is hot. I saw a lot of people over-weight two years ago in health care and biotech, only to get hammered post-election. Be diversified.
No one can predict market corrections, but that does not mean we have to feel anxious about them. Use the four principles of risk tolerance, cash, diversification, and rebalancing to prepare for potential corrections—and perhaps even enjoy peace of mind in the meantime that you have put yourself in a better position to withstand the next correction.