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Preparing For A Market Decline

| October 20, 2017
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I am not one to predict a stock market crash.

If market history has taught us anything, it's that even so-called “experts” are notoriously poor at predictions. I don’t know when the market will go down, but I know it will at some point.

History of Corrections and Bull Markets

Industries love their jargon, and finance is no exception. There are 3 common terms that refer to declining markets: a correction, a bear market, and a crash.

A correction is a market decline of 10% or more. A bear market is a market decline of at least 20%. A crash is a general term that refers to a sharp market decline, usually over a short period of time.

Capital Research and Management examined all the corrections and bear markets since 1900. They studied market declines and how often, on average, they occur. Their findings are as follows:

  • 5% declines happened about 3 times a year
  • 10% declines happened about once per year
  • 15% declines happened about once every 2 years
  • 20% declines happened about once every 3.5 years

Source: Wealthfront

It can be hard to believe that these types of declines are so common. It is easy to forget when we're in the middle of a market that has been increasing since 2009.

We know that declines have happened and will happen in the future, we just don't know when.

So, how can you prepare?

What Can You Do?

1. DON'T PREDICT

Predictions are tricky things. No one has a magic formula to determine the future movement of the markets. Economists and investment managers alike have pitiful recordstrying to foresee downturns. Economist Paul Samuelson once said, “The stock market has called nine of the last five recessions.”

If the pros can’t do it, you shouldn’t either.

2. EXPECT IT

As you can see above, stock market declines are a regular part of investing. So, it should not come as a surprise when the market inevitably drops (again… and again).

3. STAY THE COURSE

People love to gloat about how they got out of the market at the right time. But you hardly ever hear them brag about how they got back in at the right time. You can't just be right once, you have to be right twice- on the way out and on the way in. Both are equally unlikely.

Markets fall, but they have always recovered. Trying to time the market will almost always fail. People (professionals too) who try end up getting out too late, and back in after most of the recovery. They hurt themselves on both ends, rather than staying the course.

A recent DALBAR study found that investors who consistently exit the markets when they drop cost themselves, on average, 4% a year!

4. CHECK YOUR ALLOCATION

Your best protection from a market downturn is a well-diversified and allocated portfolio.

A well-diversified portfolio consists of many types of holdings, companies, and industries. Just because you have a lot of holdings, doesn't mean that you're diversified. Sometimes a single fund can be more diversified than 10. 

A well-allocated portfolio is one that reflects your risk tolerance, time horizon, and goals. The closer you are to pulling money from your investments, the more conservative they should be.

These two things won't protect you from losing money in the market, but they will help you mitigate that risk.

The last thing you want is to have a short time horizon and poor diversification and allocation when the market drops.

5. REBALANCE

One of the most important things that you can do is to rebalance your investments regularly. In a well-diversified portfolio, different asset classes produce different returns. This means that your allocation changes over time. Periodically, you need to bring your investments back to their original allocations. This process ensures that you are not taking on more risk than you should be. It also forces you to sell things that are high in the portfolio and buy things that are low- a core discipline of investing.

There has been a lot of debate and study over how often you should rebalance. I’ll spare you the extensive research and let you in on the consensus:

The average investor should monitor their portfolio at least annually and rebalance any positions that exceed 5% more or less than the original allocation.

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