When stock prices are falling, some investors find themselves
trapped in a vicious emotional cycle: fear of losing money often
leads to anger, and anger can lead to a quick, poorly planned
decision. But investors who have taken steps to prepare their
portfolio for occasional market drops generally are better able to
manage their emotions when stock prices head south.
A stock market correction is defined as a time when major market
indexes drop between 10% and 20%. Declines greater than 20% are
considered to be bear markets. Since 2000, stocks have experienced
a correction several times and there have been two bear
Sizing Up Your Portfolio
If confronted with a market correction or bear market, take time
to review your portfolio. Are all your investments in stocks or
stock mutual funds? Do you own just one stock mutual fund? Have you
invested in only a few high-flying stocks?
Remember, all investments involve risk. As a long-term investor,
you can afford to ignore short-term price changes. But you can also
make the long journey a little more enjoyable by taking a few steps
to help protect your portfolio from a drop in stock prices. Here's
a short list of some risks you face as a holder of stocks or stock
mutual funds, and some ideas about how to reduce the chances that
your portfolio suffers a big loss.
Market risk is common to all investments. If stock prices fall,
market risk says your stocks or stock mutual funds are likely to
drop in price as well. You can reduce market risk to stocks by
allocating part of your portfolio to other assets, such as bonds or
bond mutual funds and Treasury bills or money market
funds.1 When stock prices decline, it's possible that a
rise in your bond or money market investment will help cushion the
fall. Investment in a money market fund is neither insured nor
guaranteed by the U.S. government, and there can be no guarantee
that the fund will maintain a stable $1 share price. The fund's
yield will vary.
Another risk to avoid is underdiversification. If you only own a
couple of stocks, you are extremely vulnerable if one suffers a big
decline. Experts recommend that stock investors hold at least eight
stocks. If one stock falls sharply, the drop will have a limited
influence on your portfolio. Also, it's important that each of the
eight stocks be in a different industry group. Owning eight
computer-related stocks will do you little good when the prospects
dim for the computer industry. Underdiversification is also a risk
with mutual funds. If you own only one aggressive growth mutual
fund, it's likely to fall sharply if the S&P 500 drops by more
than 10%. You can temper the risk by holding a few stock mutual
funds with different investment objectives. Diversification does
not protect an investor from potential loss.
Volatility risk is a consideration, but it generally is not as
important to an investor with a long-term time horizon. Someone who
is investing for retirement in 30 years should not be too concerned
if the investment bounces around from one day to the next. What is
important is that the investment continues to perform up to
expectations. You can cut volatility risk by investing the money
you may need in the next five years in a more conservative
investment. Be more aggressive with the money you earmarked for use
in 15 to 20 years.
Missing the Best Days
|Missing the market's top-performing days can prove costly. This
chart shows how a $10,000 investment would have been affected by
missing the market's top-performing days over the 20-year period
from January 1, 1993, to December 31, 2012. For example, an
individual who remained invested for the entire time period would
have accumulated $51,404, while an investor who missed just five of
the top-performing days during that period would have accumulated
Source: Standard & Poor's. Stocks are represented by Standard
& Poor's Composite Index of 500 Stocks, an unmanaged index that
is generally considered representative of the U.S. stock market.
Past performance is not a guarantee of future results. Performance
shown is not indicative of the performance of any particular
Consider Value Stocks
Understanding downside risk is critical. Owning a stock that
drops 50% in value can have a devastating impact on a portfolio.
The next stock you own would have to climb 100% to offset that
initial decline. You can potentially cut downside risk by avoiding
stocks that trade with price/earnings ratios above 20. When the
stock market does retreat, these expensive stocks often fall the
furthest. Look for issues with more reasonable P/E ratios -- often
called value stocks -- that pay solid dividends. Mutual fund
investors should look for funds that invest in similar types of
Finally, investors need to be aware of liquidity risk. If you
invest in a stock that "trades by appointment only," you may get a
low price if you are forced to sell the issue on short notice. You
may be able to reduce liquidity risk by focusing on large, actively
traded companies such as the issues included in the S&P 500.
Generally, mutual fund investors do not have to worry about
liquidity risk. But if you invest with a small mutual fund company,
make sure you understand the rules about withdrawing funds before
sending money. Upon redemption, shares in a mutual fund may be
worth more or less than the original principal invested.
Total Annual Returns for the S&P
|If the prospect of the market falling scares you, consider this
chart. In the past 25 years the S&P 500 has recorded only five
years of negative returns, and only once has the index finished on
the negative side for three consecutive years. Keep in mind that
investors cannot directly purchase an index, and past performance
cannot guarantee future results (CS000142).
A Healthy Market Decline
It's important to remember that periods of falling prices are a
natural and healthy part of investing in the stock market. While
some investors will use a variety of trading tools, including
individual stock and stock index options, to hedge their portfolios
against a sudden drop in the market, perhaps the best move you can
make is limiting your overall risk position.
One risk that some investors may be exposed to is the risk of
falling short of reaching a long-term financial goal. Investing too
conservatively may contribute to not reaching an accumulation
target. Remember that despite several down cycles, stock prices
have historically risen over longer time periods. (Past
performance, however, does not guarantee future results.)
Points to Remember
- A correction is defined as a period when major market indexes
drop between 10% and 20%, and a bear market is when stocks decline
more than 20%.
- If stock prices are falling, market risk says that your stocks
or stock mutual funds are likely to decline as well.
- Eliminate underdiversification risk by investing in at least
eight stocks in eight different industry groups or by investing in
a few stock mutual funds with different investment objectives.
- Volatility risk is a consideration, but the longer your time
horizon the less you should be concerned with day-to-day price
- The downside risk with stocks that have high price/earnings
ratios is great. You can limit downside risk by investing in stocks
with reasonable P/E ratios and in mutual funds that concentrate on
- Investing in large, actively traded stocks may help reduce
liquidity risk. Mutual fund investors should understand the rules
of withdrawing funds before sending money.