Don’t Panic; Prepare: What To Do Before the Next Market Correction
Before the most recent market correction of late-January and early-February this year, investors hadn’t experienced 10% (or greater) retreat in market prices since January 2016. The bull market that seemingly produced a new record high each week in 2017 was confronted with historic market realities in early 2018.
Now that we have experienced some volatility in 2018, we need to prepare ourselves for the next market correction. There’s no telling when it will come, but a savvy investor is one who is aware of the market’s history of volatility and has a game plan for achieving long-term investment goals, even when the market takes an unexpected turn.
Market Corrections are Sharp and Shocking but Not Atypical
Volatility in the markets is not atypical, in fact, it is quite normal. History tells us that corrections – sudden drops of at least 10% – are an inevitable feature of the stock market. While they are difficult to predict (and therefore impossible to time), they are a natural market occurrence that deserve investor awareness and preparedness, not panic and impulsive reaction.
Corrections are usually sharp and quick. Between 1928 and 2017, the S&P 500 index has typically dropped 10% at least one time per year. Minor drawbacks of at least 5% are an even more frequent occurrence.
The table and graph below from JP Morgan show S&P 500 drawdowns from more than 80 years of market data. The takeaway is clear: a 10% decline from a recent market peak happens regularly. A year like 2017, without a 5% drawdown, is actually quite rare. The last three times that happened were 1995, 1993, and 1964.
Graphics Source: JP Morgan, Investing with composure in volatile market
Establish a Financial Plan and Stay the Course
Creating and sticking to a financial plan – a road map of where you are and want to be financially – will keep you from making knee jerk moves in response to market declines that you may later regret. The establishment of a financial plan will help you see the big picture, set both short-term and long-term goals for your investments, and keep you focused on meeting those goals no matter the market volatility.
Your plan should lay out your goals, your needs, your wants, your current balance sheet, your investments, all of your assets. It will show how your assets are currently allocated (categorized) and whether the current asset allocation will allow you to meet your goals.
Working with a wealth advisor, investors can put together an investment strategy that looks at the correct asset allocation for your specific circumstances and goals. Your plan should take into consideration your liquidity needs, risk tolerance, tax implications, concentration of stock, and your time horizon. Staying focused on your goals will help during periods of financial turmoil. A financial planner can be a great partner for making an informed reassessment of your portfolio after a market adjustment in order to ultimately reach your investment goals.
Investing for the Long Term
Everyone talks about a long-term time horizon…but what does that mean exactly? For starters, if you are going to need your assets in the next few years, allocating 100% of your investments to stocks is probably not a good idea. In the short-term, the markets can move in the wrong direction and you may risk losing much needed funds due to the volatility of the market.
Generally, if your financial goals have a horizon of 5 years or less in the future, you want to choose investments that first and foremost provide capital preservation.
However, if your goals are medium-term – 5 to 10 years in the future – a more balanced approach that introduces more market risk is usually more appropriate. The longer the investment horizon, the more a one can take on equity market risk. A time horizon of 10 years or greater will allow sufficient time for your investments to endure short-term instability, recover from loss, and grow with steady patience in the long run.
Graphic Source: FactSet, Robert Shiller, J.P. Morgan Asset Management. Returns reflect S&P 500 annual rolling period total returns except for one-month returns which are price returns and do not include dividends. Represents period from 12/31/1929-12/31/2017
Don’t Miss the Market’s Best Days: Stay Invested Through the Bad to Experience the Good
When the markets get volatile, investors may feel tempted to sell before things get even worse. Don’t commit this common investing mistake. In reality, the data shows that investors who try to time the market, jumping in and out to avoid bad days of trading, end up missing out on the market’s best days.
The following chart illustrates this point. Missing the best 40 days in the market from January 1, 2003 through December 31, 2017 would have provided a negative return. Conversely, staying invested during the market’s ups and downs would have produced a positive return, gaining close to 10%. Even just missing the market’s 10 best days in that period would have decreased that 10% return to just 5%. Staying invested, even in times of great market anxiety, is the best long-term strategy for any investor.
Graphic source: Putnam Investments
Investors Should Have Cash Saved for Expenses and Emergencies
Every responsible investor should have cash on the side to cover all immediate expenses and a fund for emergencies.
There is no clearly defined magic number for the amount of finances that one should hold on the side. However, most people will want to have 3-6 months’ worth of income to cover your personal and/or family expenses.
To be sure, budget for all recurring monthly expenses, including housing, food, utilities, transportation, debt, health care (including insurance), and any other regular personal spend. Anything you would cut out of your budget in the case of an emergency does not have to be included – vacations, entertainment, non-essential expenses. Having an “emergency fund” will help you sleep at night when markets are in correction mode and you see your investments take a temporary drop.
While stock market corrections are not fun for us as investors, they are normal. Just because we had not experienced a correction in a while does not mean that we should react sharply. Being prepared with the correct understanding of the market’s historical behavior, as well as a thoughtful investment plan, will allow investors to ride volatility out without feelings of panic.