How to Weather a Stock Market Correction

Investment prices rise and fall, sometimes by significant amounts at a stretch. A sustained increase in prices is called a bull market. A sustained drop of 10% to 20% is called a correction; a sustained drop of more than 20%, a bear market. All three conditions are facts of market life.

In the stock market, periods of sustained increase and periods of sustained decline have tended to alternate over time. What's more, as a general rule, the periods of increase have tended to outweigh the periods of decline. As a result, equities generally appear to have had the strongest average performance of any investment class over the long run, although past performance is no guarantee of future results.¹

If it were merely a matter of arithmetic, it could be relatively simple for an investor to wait out a market dip for the next recovery. But how investors feel about their portfolios can be just as important. Price dips tend to stoke investors' fears. So, when stock prices begin falling, many investors tend to act quickly and make poor decisions, adversely affecting their financial condition.

On the other hand, investors who have taken steps to prepare their portfolios for occasional market drops generally are better able to manage their emotions when stock prices head south. They could make thoughtful changes but only where there would be solid rationales to support them.

Sizing Up Your Portfolio

While the best portfolio design anticipates all possibilities from the outset, you can improve your planning at any time. So, if confronted with an unanticipated market condition, 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 should not focus on short-term volatility. But you can also make the long journey a little more enjoyable by taking a few steps during a market correction. Here's a short list of some risks you may face as a holder of stocks or stock mutual funds and some ideas about how to potentially reduce the chances that your portfolio suffers a big loss.

• Overly narrow asset allocation. You can reduce market risk attributable 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.² When stock prices decline, it's possible that a rise in your bond or money market investment will help cushion the fall. Keep in mind that 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.
• Underdiversification. If you own only a couple of stocks, you are extremely vulnerable if one suffers a big decline. Experts recommend that stock investors hold several stocks in different industries. That way, if one stock falls sharply, the drop will have a limited influence on your portfolio. Underdiversification is also a risk with mutual funds, a risk you may temper by holding a few stock mutual funds with different investment objectives. Diversification does not protect an investor from potential loss.
• Downside risk. 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 reduce downside risk by focusing on less volatile stocks. Also consider looking for issues that pay solid dividends. Mutual fund investors should look for funds that invest in similar types of stocks.
• Volatility. Someone who is investing for the long term 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. You may want to be more aggressive with the money you earmarked for use in 15 to 20 years.
• Liquidity risk. When a particular investment is said to have a liquid market, it typically means that you can readily buy or sell a position at or near the most recent previously reported selling price. On the other hand, investments that are illiquid may not have a ready buyer for positions you want to sell or a ready seller for positions you might want to buy. In those cases, you might be forced to accept a steep premium or discount from the most recent previous price in order to execute a trade. The size of the deviation is one measure of liquidity risk; another is the potential delay between ordering a trade and executing it. The brokers' term for trades in investments with the lowest levels of liquidity is "trades by appointment only."
  

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. Investors who are concerned about this risk can consider strategies to help them limit their overall investment 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.)