What If the Stock Market Crashes?

As of this writing, the Dow Jones Industrial Average is at 14,040, about 100 points from obtaining an all-time high experienced in 2007. Since the bottom of the most recent market crash on March 9, 2009, the Dow’s value has increased 138%. Is the market overheated? Are we due for a significant pullback?

An opposing view is that when 2012 ended, the S&P 500 was below its 1999 value, despite the fact that its earnings and dividends have doubled since that time. By this measurement, the recent rally has simply brought the market to a price that is representative of its value, and no market correction is necessary.

What the stock market will do in the near future is anyone’s guess. As uncertainty is always a factor when investing, developing a portfolio that is representative of your tolerance for risk and investment time horizon is absolutely critical. Many investors realize they need to scale back the assertiveness of their portfolio as they approach retirement, but is it clear why this is important?

The mechanics of an investment portfolio are very different for a portfolio in the distribution phase than it is for a portfolio still accumulating assets. If an investor is taking withdrawals from their retirement account, it is much more difficult to recover from losses because distributions only serve to exacerbate the market decline.

As Craig Israelsen points out with the following illustration, a portfolio enduring annual 5% withdrawals faces a much steeper climb back to break even after a loss than does an accumulation portfolio:

Portfolio Loss	Required Annualized Return To Restore Original Portfolio Value After a Loss
	Accumulation Portfolio
	Within 1 Year	Within 2 Years	Within 3 Years	Within 4 Years	Within 5 Years
-10%	11.1%	5.4%	3.6%	2.7%	2.1%
-20%	25%	11.8%	7.7%	5.7%	4.6%
-30%	42.9%	19.5%	12.6%	9.3%	7.4%
Portfolio Loss	Portfolio Enduring 5% Annual Withdrawals
	Within 1 Year	Within 2 Years	Within 3 Years	Within 4 Years	Within 5 Years
-10%	23.7%	14.4%	11.5%	10.1%	9.4%
-20%	40.2%	22%	16.5%	14%	12.5%
-30%	61.8%	31.3%	22.6%	18.5%	16.2%

Clearly, the conclusion is if you are currently taking distributions from your account, or intend to do so soon, it is vitally important to avoid large losses. As it may be realistic for investors still accumulating assets to recover from a -20% loss by obtaining an average annualized return of 7.7% for three years, it is extremely unlikely that a retiree taking distributions from his account will get the 16.5% annual return required for three years in order to recover from a similar loss.

Protect yourself from unsustainable losses by maintaining adequate diversification within your portfolio. Bonds serve as a buffer against volatility. More exposure to bonds will likely decrease your loss during the next stock market correction. Additionally, ensure your portfolio has sufficient exposure to various asset classes: large cap, mid cap, and small cap stocks; US, international, and emerging market stocks; government, corporate, international, and emerging market bonds. Investing in multiple asset categories will protect your portfolio from a catastrophic loss next time a bubble in a market sector pops.

Speak with a financial planner to ensure your portfolio is assertive enough to meet your retirement goals while maintaining an acceptable level of risk. If you wait for the market to cool off before taking action, it may be too late.