Did the market downturn at the end of 2018 have you feeling queasy? It might be time to check in on your portfolio and make sure you’re ready for the next recession.
While the market has recovered well since its Christmas Eve low, downturns and upswings are normal and to be expected. The next downturn could be tomorrow, or next month, or in three years. But the market is volatile, and if you want to reap the potential long-term benefits of investing, you need to be ready for the shorter-term fluctuations.
Downturns in the stock market are when many investors may get scared and make mistakes that impact their future wealth. Preparing now, while the waters are calm, can help save you from some stress when the rockier days come.
What causes market downturns?
It would be fantastic if the stock market just increased steadily month after month and year after year. But the reality is that all investing involves risk. Lower risk investments offer lower return potential compared to higher risk investments. Higher return potential corresponds with higher risk.
Ideally, the stock market should reflect the expected future value of companies, often evaluated through cash generation or multiples of earnings. During a recession, cash generation and profits fall, bringing stock prices down with them.
But while fundamentals are important, the reality is that emotions, especially greed and fear, move markets. When investors have a crisis of confidence, are worried about a future economic recession or political crisis, or have simply over-invested for too long, the market tends to come down for a period of time.
Emotions can cause market prices to overreact. We get overexcited in a good economy, driving up stock valuations. When things look less rosy, we sell in a panic. So, while long-term economic growth is what has created a history of stock market growth, any given month or year can have major swings.
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How to know if you’re prepared for a market downturn
We’re now more than 10 years past the last recession (2008), which means many new investors have never experienced the scary feeling of watching their assets fall significantly. It’s easy to invest when the market is going up. But making smart decisions when things are going down is an important part of building wealth.
If you’ve never been through a downturn, or you haven’t checked your portfolio for readiness lately, now is a good time to get things in order.
First, assess your risk tolerance.
- Do you plan to need the money from your investments in five years? Ten? Thirty?
- Are you confident in the long-term growth of the stock market and will you be capable (financially and emotionally) of staying invested through market declines? Or would you be more comfortable with somewhat slower, but potentially more stable, growth?
Assessing your risk tolerance can help you determine your target asset allocation. If you need your money in the near- to medium-term, or you want less volatility, you may want a higher percentage of investment grade bonds in your portfolio. If you’re far from retirement, a higher portion of stocks might be right for you.
Making sure your asset allocation is right for you can help ensure that you won’t see more volatility than you can handle in the next downturn. If you’re not sure what your asset allocation should be, this free questionnaire from Vanguard takes into account your goals, time frame, financial situation and experience to suggest an allocation. Keep in mind that while asset allocation widely recognized as a risk mitigation technique based on your time horizon and risk tolerance, asset allocation can’t eliminate the risk of loss.
How to reduce risk in your portfolio so market turmoil doesn’t keep you up at night
Even if your asset allocation is aligned with your risk tolerance and investment goals, seeing the balance of your hard earned savings fall isn’t a comforting thing. To make the experience as stress-free as possible, consider doing these three things:
1. Know your goals
You started investing for a reason. Whether you wanted to prepare for retirement, save for your dream home or pay for your child’s education, you had a goal. Revisit your goals, why they matter to you, and how far in the future they are.
Understanding your goals will help you evaluate a portfolio allocation that you can be comfortable with. Keeping your goals front-of-mind may also help you weather the short-term storms: you’ll know that the near-term ups and downs are worth it to get where you want to go.
2. Diversify your investments
Consider spreading your investment eggs around to multiple baskets. One way to help reduce risk in your portfolio is to invest across sectors – tech, healthcare, industrials, utilities, and more.
Free tools at Future Advisor or Personal Capital will allow you to link all your investment accounts (401Ks, IRAs, 529s, and taxable accounts) and get an overall picture of your current asset allocation and the diversity of your portfolio.
Low-cost index funds that instantly diversify your investments across all companies in the stock or bond market can be a way to reduce exposure to any one industry or stock.
3. Shift towards fixed-income
If as you evaluate your portfolio, you find that you’re worried about facing a downturn or needing your money in the near-term, you can consider shifting your assets from higher-risk stocks to lower-risk bonds. Keep in mind there are multiple forms of bonds and they have different risk characteristics. One type of bond risk is default risk. This is the risk that the bond issuer does not make interest payments or even defaults on repayment of the principal. Default risk is generally associated with the financial strength and debt-paying ability of the issuer.
Companies that do not have a good credit rating, because they may be in financial distress, have a high debt level, or for other reasons, issue high-yield or junk bonds. While these may offer high potential interest payments, they also have a higher risk of default. In a market downturn, holding these types of bonds won’t necessarily reduce your risk exposure. Instead, consider U.S. Treasury bonds and investment-grade bonds that are less susceptible to default risk, making them a good option to diversify risk.
As you prepare for the next downturn, having a slightly higher percentage of U.S. Treasuries or investment-grade bonds then might typically be recommended can be a smart choice for investors who are new to the market and aren’t sure how they’ll stomach recessions yet.
Downturns are part of investing
The markets will always cycle up and down. It’s just part of investing. Potential long-term returns in the stock market are your compensation for the risk you take on. While you’ll never be able to prevent downturns, you can expect and prepare for them.
It’s a good idea to stay on top of your asset allocation, understand your goals, and resist the urge to alter your normal investment plans due to headlines.
This too shall pass.
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Chelsea Brennan is the founder of Smart Money Mamas, a personal finance blog that focuses on family finance, investing, and reducing money stress. Chelsea is an ex-hedge fund investor whose work has appeared in a wide array of publications, including Forbes, Business Insider, and more.
Haven Life Insurance Agency (Haven Life) does not provide tax, legal or investment advice. This material has been prepared for informational/educational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or investment advice. You should consult your own tax, legal, and investment advisors before engaging in any transaction or strategy.