With stocks at record highs, this is the time to think about how to handle a market correction because no stock is immune to the pull of gravity. While no one is calling for a 2008-style market crash, experts say you should review risk management strategies long before the market sours. That way your strategy to minimize losses is already in place.
[See: 10 Long-Term Investing Strategies That Work.]
Investors who prepare now for a pullback won’t panic when it happens, says Kathy Carey, director of asset manager research for Baird’s Private Wealth Management.
Have a plan. If you don’t have a plan, create one — starting with identifying your financial goals and the return needed to meet them. Chances are, you may have already met your goal for the year.
“It’s great to see your 401(k) statement going up like this, but we’ve already seen a 9 percent return in the S&P 500 this year,” Carey says. “When people are typically looking at a financial plan, they’re thinking of an 8 percent return; you’ve already got it.”
Of course, a turbocharged stock market has a way of knocking a portfolio out of balance by pumping up some assets more than others. Investors, especially those nervous about a market pullback, should rebalance their portfolio to get their asset allocation back to its starting position, Carey says. Normally, financial advisors recommend routinely rebalancing a portfolio at the beginning of each year, but it’s also a good idea to do so after a string of gains to lock in those profits.
Every financial plan has a purpose. Are you investing for short-term needs like college tuition in a few months, long-term needs like retirement or something in the interim, like a kitchen remodel a few years away?
Savings that need to be tapped soon should be kept in a cash account, such as a money market.
Carey suggests that people with medium-term goals who are nervous about the stock market’s rich valuations talk to a financial advisor about transitioning that money, especially if they don’t have a plan. She says these investors can sell some winners now to protect those gains and start moving funds to less risky investments as the investing goal nears.
If the money is for a retirement more than 10 years away, stay put because “you don’t need to make tactical moves in the market,” she says.
Take profits. It’s easy to be myopic when stocks are flying high, says John Person, president of NationalFutures.com in North Palm Beach, Florida. As someone who has been involved in markets for more than 25 years, he says investors often hesitate to take profits because they’re afraid of missing out on further gains. That’s especially true for people who are holding on to hot stocks that are getting a lot of press and predictions for even greater price gains, he adds. But take those predictions with a grain of salt.
[See: The Fastest Ways to Lose Money in the Stock Market.]
“If a fund manager says on TV that Amazon (ticker: AMZN) is going to go from $1,000 to $2,000 in five years, he doesn’t know that,” Person says. “There could be some type of a competition, destructive innovation that could change the entire landscape. The fact is nobody knows what’s going to happen, and having one bird in the hand is worth two in the bush when it comes to protecting your own assets.”
In fact, trimming a position to raise cash is what professional investors would do. By cashing in some of those gains, professionals not only lock in profits but also have the money on hand to buy back the security at a lower price during the inevitable market swings.
“If it’s good enough for Warren Buffet to trim position and raise cash, it’s good enough for you,” Person says.
Use options as insurance. Portfolio diversification is another way to weather financial downturns as it’s unlikely all asset classes would fall at the same time, Carey says. She recommends a portfolio that is 60 percent equity and 40 percent fixed income, with 45 percent U.S. and 15 percent international for both.
Sophisticated investors might consider using options as portfolio protection, especially if they’re concerned about covering a position for a certain time frame, says Steve Claussen, vice president of product management and trader strategy at E-Trade and an options expert.
Options are the right, but not the obligation, to buy or sell a security at a fixed price at a future date. One strategy for protecting an entire portfolio for a few months is to buy a put option on an exchange-traded fund that follows a broad market index — for example, the SPDR S&P 500 ETF ( SPY). Buying a put is like homeowner’s insurance in that investors pay a small premium to protect a much larger and more valuable asset, he says.
If the broader market falls, the value of the put increases, and the put owner can sell the option, using the proceeds to help offset losses in a portfolio, Claussen says. If the market rises during this time, the put owner loses money on the put, but the value of the portfolio goes up.
[Read: The Difference Between Trading Futures and Stock Options.]
“While they’re not insurance products, put options give you a guarantee to sell at a certain price,” thereby locking in a position that may prove valuable later on, he says.
More from U.S. News
9 Investing Myths That People Still Believe
The Top 10 Investment Portfolio for Millennials
7 ETFs That Let You Invest With the ‘Smart Money’
3 Ways to Prepare for a Market Correction originally appeared on usnews.com
