Did you know we’re in the longest-lasting bull market since the period from October 1990 to March 2000? If you are an investor, this is fantastic news for you. But sometimes, it doesn’t feel that way.
The more you have, the more you have to lose. Should you take your gains off the table? How likely is a correction, anyway, and how worried should you be?
What is a correction? A correction is simply a drop in the price of an asset of 10 percent or more. Commentators often refer to it as the market “entering correction territory” for added gravitas — it means exactly the same. It is simply a term used for a specific amount the market drops.
[See: 10 Reasons Warren Buffett Is a Better Investor Than You.]
Remember, a correction may take more than a couple of days to play out — and it will likely encompass both up and down days within the correction.
Corrections don’t normally happen in a straight line down. You will really only know for sure it was a correction in hindsight.
How often do corrections occur? According to a study from the Capital Research and Management Co. that examined the average frequency of market corrections from 1900-2010, a correction of 10 percent occurs about once a year on average. Downturns of 5 percent take place about three times per year on average.
The average American lives to be 78.5 years old. Assuming someone begins investing at age 30, there is the potential to live through at least 48 corrections. If you plan to live through this many corrections, it is important to prepare for them, so that they do not cause you undue angst.
What causes corrections? Pretty much anything. And they typically can’t be predicted with accuracy ahead of time.
For many investors, the financial crises of 2001 and 2008 do not feel that far away, and after these events, the negative headlines never stopped.
Remember the BP oil spill, the European debt crisis, the U.S. government shutdown, the “Taper Tantrum,” the Ebola fears, Brexit, or the worst-ever start to the year for equities (2016)? This is just a small sampling of the various things investors have been told to panic about over the past 10 years.
With each potential threat, investors are encouraged to panic and worry about short-term events completely out of their control. While these are all serious events, the magnitude of panic doesn’t necessarily correlate to the magnitude of the actual risk to one’s portfolio.
[See: 10 Long-Term Strategies That Work.]
What should I do to prepare for a correction? Market corrections are not something we can control, but we can prepare for them. Those investors with more risk than they can really afford are the ones who worry. Basically, it is important to always be prepared for the volatility we know will happen, we just don’t know when.
Prior to a correction, investors should ask themselves the following questions:
Do I have an appropriate allocation? This means having an appropriate balance of risk and return in your portfolio, for your needs. For example, an investor close to retirement needs to begin accessing their money within the next few years. Being over-exposed to the ups and downs of equities could be very harmful, and perhaps a tilt toward fixed income would be more appropriate.
Am I saving enough? Saving is an excellent way to reduce anxieties about having enough money for your future, because it is a “return” completely within your control. In other words, identifying specific financial goals and saving for those goals is within your control.
Am I diversified? When you have a diversified portfolio, ideally one asset class will compensate when another goes down. Investors cannot predict which will go up and down at which time, so it is a good idea to hold a mix of asset classes in an allocation appropriate to your risk/return needs.
When is the last time I rebalanced? As your investments go up and down in value, your allocation may drift away from what you intend. This could result in your portfolio having more or less risk exposure than you need. Rebalancing alleviates the impact of this.
Am I overpaying? In bull and bear markets, being cost-efficient and tax-efficient is a great way to increase your performance. In investing, you keep what you don’t pay for — and it is thus available to compound and grow over time.
What should I do during a correction? Ideally, nothing. A correction may provide some opportunities to rebalance or purchase certain assets at a discount if you have cash available — but in most cases, the best course of action is to remember your long-term goals. Stay focused and do not let fear dictate your plan.
Selling assets during a correction only locks in losses and is counterproductive to the idea of buying low and selling high.
[See: 7 Investing Lessons Dad Forgot to Teach You.]
What should I do after a correction? If you have a plan in place, you shouldn’t have to ‘do’ anything. Savvy investors know that corrections are simply part of the market cycle. They tune out the noise of headlines and speculation as to why “It’s different this time.” They know that a complete strategy overhaul is not needed for “the new normal” because in all likelihood, it’s just a change in the market cycle that their portfolios are built to withstand. They understand that a correction is probably the worst time to make a dramatic change anyway, since the research consistently shows that jumping in and out during volatile periods can be very costly to long-term returns.
Many of the questions above for corrections also apply to bear markets (a drop of 20 percent or more). The key is having your financial life and portfolio allocation prepared in advance. With a suitable allocation in place, corrections and bear markets should have limited impact on your long-term plans.
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Questions to Prep for a Market Correction originally appeared on usnews.com
