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• How to Weather a Stock Market Correction

How to Weather a Stock Market Correction

written on February 25, 2009 by Frank Fantozzi

When equity market prices are falling, some investors find themselves trapped in a vicious emotional cycle: fear of losing money often leads to anger, and anger can lead to a quick, poorly planned decision.  But investors who have taken steps to prepare their portfolio for occasional market drops generally are better able to manage their emotions when equity prices head south.

A stock market correction is defined as a time when major market indexes drop between 10% and 20%.  Declines greater than 20% are considered to be bear markets.  In the past 10 years, Standard & Poor's Composite Index of 500 Stocks has experienced a correction several times, and a bear market early on in the new millennium.

Sizing Up Your Portfolio
If confronted with a market correction or bear market, take time to review your portfolio.  Are all your investments in stocks or stock mutual funds?  Are your equities invested in similar companies and or industries?  Have you invested in only a few high-flying stocks?  Are you constantly changing investments by chasing last year returns?  Do you utilize other asset classes besides equities and fixed income?  Have you honestly assessed your risk tolerance and incorporated your use of money with the development of your investment strategy?

Remember, all investments involve risk.  As a long-term investor, you may not be able to afford to ignore short-term price changes.  But you can also make the long journey a little more enjoyable by taking a few steps to help protect your portfolio from a drop in equity prices.  Maintaining a well thought out and consistent strategy is one key to potentially long term success.

Here is a short list of some risks you face as a holder of stocks or stock mutual funds, and some ideas about how to potentially reduce the chances that your portfolio suffers a big loss while weathering market corrections.

Limiting Risks
Market risk is common to all investments.  You can potentially reduce market risk from stocks by allocating part of your portfolio to other assets, such as bonds or bond mutual funds and Treasury bills or money market funds.  Other baskets often referred to as alternative investments to consider placing money to further diversify risk are non traded REITs, Long/Short Funds, Managed Futures and Structured Notes.  Also note that alternative investments and fixed income investment also have their share of risks to factor.  The goal is not to have investment classes that correlate.  In other words, if one type of investment does poorly, the other assets classes generally do not follow.

Another risk to avoid is under diversification.  If you only have several stocks, you are extremely vulnerable if one suffers a big decline.  Some experts typically recommend that stock investors hold at least eight stocks.  If one stock falls sharply, the drop will have a limited influence on your portfolio.  Also, it's important that each of the eight stocks be in a different industry group.  Owning eight computer-related stocks will do you little good when the prospects dim for the computer industry.

Under diversification is also a risk with mutual funds.  If you own only one aggressive growth mutual fund, it's likely to fall sharply if the S&P 500 drops by more than 10%.  You can potentially temper the risk by holding a few stock mutual funds with different investment objectives.  Diversification does not protect an investor from potential loss.  There is no guarantee that a diversified portfolio will enhance returns or out perform a non diversified portfolio.  Also the underlying holdings of the mutual funds matter.  Many people feel safe that they own several mutual funds only to find out they are managed and invested in similar companies and industries thus they act in a similar manner.

Volatility risk is a consideration, but it generally is not as important to an investor with a long-term time horizon.  Someone who is investing for retirement in 15 to 20 years should not be as concerned if the investment bounces around from one day to the next.  What is important is that the investment continues to perform up to expectations.  You can potentially cut volatility risk by investing the money you may need in the next five years in a more conservative investment.  Be more aggressive with the money you earmarked for use in 15 to 20 years.

Also avoid chasing returns.  Investors become enamored with last year's results and constantly move their moneys to last year's "winner."  Often this tactic insures selling low and buying high.  There is often a lot of research to understand how and why a mutual fund has performed as it did.

Investors also need to be aware of marketing timing.  When the markets go south, it is common for people to think of getting out before the bottom, thinking they can just drop back in at anytime.  Market timing is a double edge sword.  Not only do you need to guess right when to get out but also guess right to get back in.  As the graph below indicates, the market does not move evenly and regularly in a down or up cycle making it highly unlikely that an investor or a professional will guess right.  The key is staying properly invested. 

Missing the Best Days of the S&P 500

Missing the market's top-performing days can prove costly.  This chart shows how a $10,000 investment in the S&P Composite Index would have been affected by missing the market's top-performing days over the 10-year period from December 31, 1997, to December 31, 2007.  For example, an individual who remained invested for the entire time period would have accumulated $17,758, while an investor who missed just five of the top-performing days during that period would have accumulated only $13,782.  This is a hypothetical example and does not represent any specific investment.  Your results may vary. Source : Stand & Poors

Consider other stock asset classes

Many investors do not realize the number of equity investment classes.  Besides the general categories of growth and value, there are large company, mid size company and small company mutual funds.  Not to mention these same categories are duplicated from domestic equities to international.  These categories while all equities, respond and cycle differently in the markets depending on the myriad of financial factors the can come into play.

Total Annual Returns for the S&P 500

If the prospect of the market falling scares you, consider this chart.  In the past 25 years the S&P 500 has recorded only five years of negative returns, and only once has the index finished on the negative side for three consecutive years.  Keep in mind that investors cannot directly purchase an index, and past performance cannot guarantee future results. Source: Standard and Poors

A Healthy Market Decline

It's important to remember that periods of falling prices are a natural and a healthy part of investing in the equity markets.  It offers those who have available cash or fixed income positions to consider buying equities at better pricing.  Besides reviewing the underlying investments, the portfolio needs to be aligned when your anticipated use of its money.  This is defined when you intend to take distributions.  Also, you need to align your portfolio with your individual tolerance for risk.  This is defined as at what point in the market drop will you feel compelled to make a change in your overall allocation?

Another risk that some investors may be exposed to is the risk of falling short of reaching a long-term financial goal.  Investing too conservatively may contribute to not reaching an accumulation target.  Remember that despite several down cycles, equity prices have historically risen steadily over time.  Past performance, however, does not guarantee future results.

For specific questions on this article or Investment Management, Life & Disability Insurance, Tax/Estate Planning, Philanthropy, and/or other financial topics, contact Frank Fantozzi at (440) 740-0130. You may also e-mail him at Frank@PlannedFinancial.com or visit http://www.plannedfinancial.com/

 

Securities offered through LPL Financial. Member FINRA/SIPC