How Well Prepared Are You Today in Anticipation of Tomorrow’s Market Downturns?
We’ve come a long way since the start of the pandemic. The country is gradually opening up, vaccines are available to all interested adults in our country, and stock market prices have skyrocketed. Home prices have also greatly increased, with most selling over asking prices.
In fact, at the writing of this article, the S&P 500 is nearing all-time highs at approximately 4,370. Interestingly, markets are forward looking and built on investor expectations. That is, they reflect what investors anticipate will happen. This is also why markets fluctuate daily in response to news. When investors sense uncertainty, volatility ensues. When investors are confident, markets continue to soar.
However, adjusting your portfolio frequently in response to negative news introduces stress in many ways, which can affect your overall investment experience. Of course, to be an investor is to experience significant declines from time to time. In fact, they happen more often than you might think. So at some point we will all have to prepare ourselves for a correction. It’s not a matter of if, but when.
Of course, nobody can consistently predict market movement or certain asset prices, but you can adequately prepare for downturns with the four simple strategies below.
1) Stick To Your Asset Allocation
If you follow finance or work with a financial advisor, then you may be familiar with diversification. Simply put, “being diversified” means having your funds in many different types of investments to minimize risk. You don’t want to have too much of your portfolio invested in one stock, investment, or asset class in case it radically underperforms.
Instead, most financial planners recommend investing in a mix of stocks, bonds, ETFs, and alternative investments, the combination of which will be based on your risk tolerance. This is commonly referred to as an asset allocation.
Asset allocation can be an investor’s most important decision and will rely heavily on risk tolerance, financial capacity to take on risk, and their timeline until retirement. Younger investors can afford to take more risk with their portfolios and have a heavier concentration of equities. Why? They have plenty of time left in the market before they retire to recover from downfalls.
Encountering a volatile market early in retirement is much riskier. This is what’s known as Sequence of Return Risk and essentially means that the sequence of investment returns and inflation during the early years of retirement will have an enormous impact on a retiree’s financial security. There is a real risk of experiencing low or negative returns early in retirement just as withdrawals begin. Years of negative returns could (1) deplete a portfolio faster than desired or expected and/or (2) create a need for retirees to spend less than anticipated.
It should be noted that sequence of returns also has tremendous upside potential should the market have positive investment returns throughout the first few years or decade of retirement. While a negative sequence of returns could result in an undesired reduction in retirement spending or depletion of a portfolio before anticipated, a positive sequence of returns could quickly compound the portfolio and increase funds available for ongoing withdrawal and legacy goals.
Sequencing risk will cause safe withdrawal rates to vary, sometimes significantly! Because sequence of returns is determined by the date portfolio withdrawals begin, they cannot be known and factored in ahead of retirement.
The challenge then is not only to determine a reasonable amount of spending that can withstand a potential downturn should one occur right before or right after retirement, but to also position the portfolio to capture the benefits of an upswing should one occur.
2) Rebalance Regularly
You’ll also want to regularly re-balance your portfolio to keep your risk at the desired level. Market movement in either direction can skew your allocation if it isn’t monitored and re-balanced from time to time. For example, if you have a 50/50% asset allocation between stocks and bonds, and stocks appreciate, you could end up with a 70/30% stock to bond asset allocation thus exposing your portfolio to unintended risk.
3) Continue Investing: Dollar Cost Averaging
When investing, you could either invest a large lump sum or gradually invest smaller increments at regular intervals. The latter method is referred to as “dollar cost averaging.” Dollar cost averaging can be powerful as it keeps you from making the potentially costly mistake of timing the market.
Timing the market is a dangerous game of risk. Most investors, including professionals, struggle to match, let alone outperform, the market. Per a 2020 report, 90% of actively managed investment funds failed to outperform the broad stock market’s (i.e. the S&P 500) performance over a 15 year time frame. The more prudent alternative is investing a predetermined amount every month so you buy the same dollar amount of that investment, regardless of current price.
4) Keep Cash Reserves
Life can be unpredictable and comfort can be found in being prepared for a “rainy day.” A rainy day could refer to unexpected events like job loss, car repairs, or medical expenses that fall outside your typical budget.
Not having cash on hand for the unexpected may force a necessary liquidation of investments at a time when prices are depreciated. This is especially true of retirees who rely heavily on investment income or dividends to cover their living expenses. Nor do you want to accrue unnecessary debt while you are strapped for cash.
Most financial planners recommend having 3-6 months of net living expenses in a secure, FDIC insured, high interest savings account. Keep in mind, though, this figure is just a general rule of thumb and may not be sufficient for everyone. For example, a year’s worth of expenses put away in savings may be wanted for a commission-based professional, if one is self-employed, or cash on hand for a retiree.
The goal is to keep your funds invested for as long as possible without interruption to take advantage of the market’s historical upward trend. You don’t want to find yourself in a situation where you are taking early withdrawals from your retirement accounts or liquidating investments.
Stock and real estate markets have greatly recovered since the March 2020 crash. In fact, The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has deemed the time period between February 2020 and April 2020 the shortest recession in US history. And since then, all major market indexes have rebounded to hit record highs.
We must remain realistic in our outlook and remember that market cycles are natural and what goes up will eventually come down—if even for a short time. Your best lines of defense as a long-term, evidence-based investor are to continue investing, diversify your asset allocation, rebalance, keep some cash on hand, and reap the rewards offered by markets for being a long-term investor.
How Prepared are You for a Market Correction?
Looking for a second opinion on protecting your assets during declines? We’d love to chat with you. We are fee-only, fiduciary financial advisors serving individuals and families locally in Southern New Hampshire and virtually throughout the country. We invite you to take a look around our website to learn more about who we serve, and to book a complimentary Get Acquainted meeting by calling the office at (603) 458-2776 or booking directly here.