Preparing For a Market Correction

History tells us that over a long enough time span catastrophes are likely to occur. Fires, flooding, earthquakes – none can be prevented and all can be potentially devastating. While these events can’t always be avoided, we can prepare for them. Running practice fire drills enables us to act appropriately during misfortune while maintaining emergency food storage ensures we won’t starve when tragedy strikes.

Just as physical calamity can turn lives upside down, financial upheaval can lead to an unrecoverable loss. Fortunately, we have the ability to prepare for financial uncertainty in the same way we prepare for other exposures. As the current bull market is now both the fourth longest in history (64 months) and the fourth largest (+192% gain), now would be a perfect time to ensure you are prepared for the next market pullback.

Run a Portfolio Fire Drill

You can run a fire drill for your portfolio by understanding the loss potential of your holdings. It is critical to recognize that the amount of volatility your portfolio will experience in declining market environments is dependent on your asset allocation – how much of your account is invested in stocks vs. bonds. The larger the percentage of stocks in a portfolio, the more the portfolio’s value will increase during bull markets but decrease when the market declines. Let’s look at the historical performance and risk levels of a range of diversified stock-to-bond ratios:

Asset Allocation – Risk & Return (1970-2013)

Portfolio Allocation	Average Annual Return	Largest Loss in a Calendar Year (2008)
100% Stocks	10.85%	-39%
80% Stocks 20% Bonds	10.33%	-30%
60% Stocks 40% Bonds	9.99%	-20%
50% Stocks 50% Bonds	9.76%	-15%
40% Stocks 60% Bonds	9.49%	-11%
20% Stocks 80% Bonds	8.85%	-4%

After determining the asset allocation of your portfolio, ask yourself how you would respond to another market correction like we experienced in 2008. For this exercise, considering loss in dollar terms is particularly productive. For instance, if 80% of your portfolio is invested in stocks, you might be able to convince yourself that you could sustain a 30% loss. However, supposing you have $500k invested, a 30% loss would mean your portfolio is suddenly depleted to $350k -- $150k of hard earned money just evaporated. To many, the thought of losing $150k is more uncomfortable than the thought of a 30% loss.

Next, picture every media outlet sending warnings day after day about how the market is only going to get worse. Imagine yourself checking what the markets are doing multiple times a day and constantly being disappointed that it is another day of losses. Lastly, visualize your occasional friend, neighbor or family member bragging about how he got out of the market before the collapse and telling you how you are a fool for not doing so.

How would you respond in such an environment? Would you have a hard time sleeping or digesting your food? It’s critical to be honest with yourself. If you would stray from your long-term investment strategy by selling after a market drop and waiting for the market to recover, your current portfolio may be too aggressive. If so, scale back the assertiveness of your portfolio by reducing your stock exposure now because selling stocks during a market decline is the last thing you want to do.

Sound financial planning suggests individuals should scale back the assertiveness of their portfolio as they approach retirement. While a young worker with 30 years until retirement can afford to be aggressive and has time to recover if a large loss in suffered, a person who is closer to retirement can’t afford to endure a significant loss right before the invested funds are needed to cover life expenses.

Maintain an Emergency Financial Storage

As stocks and bonds are the long-term portion of your investment portfolio, cash equivalents are your tool for dealing with short-term spending needs. Before even investing, everyone should have an emergency reserve holding enough cash to cover three to six months of expenses. These funds should only be tapped in the event of a job loss or a medical emergency.

Additionally, investors who are taking withdrawals from their portfolio in order to meet cash flow needs should also have the equivalent of two years of necessary withdrawals in cash at all times. These funds should be used to cover living expenses during the next market correction. Having this emergency financial storage will prevent you from having to take withdrawals in a down market and allow your portfolio time to recover.  

Be Prepared

No one knows when the next bear market will come. However, just like winter follows every fall, market corrections will ultimately come after every bull market.  Preparing for such a financial downturn will ensure you act appropriately when the time comes and prevent financial catastrophe.