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How to Prepare for the Next Stock Market Downturn

November 1, 2017

California Business JournalAre we at the top yet? Selling near stock market highs and locking in profits is always tempting, especially when the current bull market is one of the longest on record and seemingly puttering out. Yes, this might be the perfect time to sell, however, let’s look at the long term odds first.

According to Check Capital’s research, the Standard & Poor’s 500 Index (S&P 500) has advanced in 78% of the years since 1950 (or about 4 out of every 5 years). Further, 95% of every five years – and 100% of each decade – since 1950 have led to a new high. These statistics are true even though the S&P 500 has had an average of 14.2% annual peak to trough dips. Volatility is normal. While the average S&P 500 annual return has been about 10%, annual returns in the 5% – 15% range surprisingly only happen about 20% of the time so expect big price swings. If your investment time horizon is longer than a few years, betting against these odds is dangerous. But sitting through another multi-year decline is equally unsavory. What to do, then?

The first question to ask yourself is this:Do I have the stomach to ride through a downtown and not get out of a moving car?” Many people still have scars from the stock market’s last two 50% drops since 2000 because panicking and selling during a downtown – the very thing you will feel like doing – is far worse than the drop itself. History shows that the general stock market has always recovered (although not every individual stock), but it takes fortitude and a disciplined plan to ride out the dips.

Without giving individual investment advice, let’s explore some helpful techniques as you aim to reach your financial goals with your stomach attached.

0 to 2-Year Time Horizon: If the time horizon is less than 2 years before you need your funds for a specific purpose, this is considered, “short-term.” For the portion of your holdings that you will need to spend in the next year or two (i.e. buying a home or paying taxes, etc.), the stock market is probably not the best investment vehicle. You will sleep better at night with these funds in a more stable investment like short-term bonds.

2 to 10-Year Time Horizon: Investment decisions within this time horizon are the trickiest as the S&P 500 returns have varied wildly over the medium term. However, the historical odds of profitability increase significantly if you can wait at least five years to spend your holdings. To reduce volatility (and potential returns), modern balanced portfolios with additional allocations to fixed income, real assets and alternatives have produced returns approaching the U.S. stock market’s with much less risk. Three other methods of handling stock market volatility risk include:

  • Keep 6 – 24 months of living expenses in near cash investments to draw from instead of the stock market, if your income sources are reduced.
  • As your time horizon for using your funds draws closer, start reducing your stock market exposure. This will limit your volatility as you approach the time you need your funds.
  • If you are still sitting in cash waiting for the perfect time to jump in (and have missed much of this bull market), start dollar-cost averaging by putting a fixed dollar amount into the markets every month for 6 – 24 months. You will buy more shares in down months and buy less in up months, giving you a “better-than-average” share price cost basis. This is “old school” and takes discipline but keeps you from making a big bet at the wrong time.

Beyond 10-Year Time Horizon: Long-term stock market investments have historically been profitable yet just as volatile. However, the magic of compounding returns over long time horizons has rewarded patient investors over the decades. If you can keep your emotions in check, hang in there for the long term. For a smoother ride, try the 2 to 10-year portfolio designs aforementioned.

Neither fear nor greed are good attitudes for investing. Rather, in my 40 years of professional experience, I’ve seen discipline and strategic planning produce not only optimal returns (balancing all investment objectives) but also a pleasant journey. It is in this balanced state where investors can feel confident that their long-term goals will be met despite short-term price movements or the nightly news.