How prepared are you, as an investor, for the next financial downturn?
Almost 650 years ago, Geoffrey Chaucer penned the adage “All good things must come to an end” as part of his epic poem “Troilus and Criseyde,” a tragic love story set during the Trojan War. The poem is a story of climactic highs followed by the darkest of lows—emotions that long-term investors are all too familiar with.
Given that we’re now eight years into the second longest bull market in U.S. stock market history, these record highs will inevitably come to an end, either by way of a much-anticipated correction (a peak-to-trough decline of at least 10 percent) or a more dramatic bear market (a peak-to-trough decline of at least 20 percent).
The silver lining to corrections and bear markets is that they’re normal, expected and necessary “resets” that enable financial markets to provide sustainable long-term growth. They’re so common that from the years 1900 through 2013, 123 corrections occurred—nearly one per year—and during that same period 32 bear markets occurred—about one every three and a half years.1
Despite the focus on major downturns, the market has historically recovered quickly. In fact, the best days in the market have typically come within two weeks of the worst days, so investors who sold during significant market declines have been heavily penalized. In a 2015 Business Insider article, Sam Ro reported that being out of the market on only the 10 best S&P 500 trading days between 1995 and 2014 would have netted an investor 3.75 percent less in annualized returns.
While timing the market is nearly impossible, investors still take this gamble all too often, seeking the “safety of cash” in a downturn. By doing so, however, most investors end up locking in losses too low and re-entering a recovering market too late; in effect, they lose not once, but twice.
So, when the next correction or bear market does come, take the approach of savvy investors by preparing ahead of time, both strategically and mentally. Here are a few strategies to consider:
Temper your emotions. Avoid the temptation to sell long-term assets by realizing that market downturns are to be expected. Historically, the market has always recovered, irrespective of the myriad reasons given why “this time is different.”
Optimize your portfolio allocation. Ensure that you have, and remain committed to, an appropriate asset allocation given your investment time horizon and risk profile across both qualified and nonqualified accounts. Within each account, having complete and thoughtful asset exposure will keep things on track for you in the long term and allow you to rebalance out of those assets that have increased in value, into assets that have been beaten down.
Aim for disciplined rebalancing. Look at extreme market volatility as an opportunity to buy low and sell high. During the lows of 2008, for example, having at least some bond exposure enabled even the most aggressive investors to rebalance from fixed income, the only asset class that was up, into other asset classes trading at depressed values.
Have an emergency fund. Plan ahead for any short-term liquidity needs by maintaining an adequate reserve of cash for any unexpected situations; enough to cover six to 12 months’ worth of expenses is a common target. This will help prevent the need to sell assets at fire-sale prices.
Consider deploying cash in a downturn. Buying into a depressed market with excess cash (beyond any emergency reserve) can be an effective way of boosting future dollar-weighted investment returns once the market recovers.
By being prepared, remaining disciplined and keeping an open line of communication with your advisor, you’ll be able to weather painful, yet temporary, market volatility and ensure that the end of one chapter of market performance simply marks the beginning of the next. As Chaucer said, “All good things must come to an end… but the best is yet to come.
1 Ro, Sam. (2015, March 12). How a few poorly-timed trades can torpedo two decades of healthy returns.
The opinions expressed are those of Saugatuck Financial as of the date stated on this article and are subject to change. There is no guarantee that any forecasts made will come to pass. All investments carry some level of risk, including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss. Saugatuck Financial is a marketing name for Justin Charise, Alfred Schor and Lou Nistico and is not a broker-dealer, registered investment advisor federal savings bank, subsidiary or other corporate affiliate of The Northwestern Mutual Life Insurance Company, including its subsidiaries, nor is it a legal partnership or entity. Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, Wis. (NM), and its subsidiaries. Charise, Schor and Nistico are representatives of Northwestern Mutual Wealth Management Company®, NMWMC Milwaukee, Wis., a subsidiary of NM and limited purpose federal savings bank, and registered representatives of Northwestern Mutual Investment Services, LLC (securities), a subsidiary of NM, registered investment advisor, broker-dealer, and member, FINRA and SIPC. All NMWMC products and services are offered only by properly credentialed representatives who operate from agency offices of NMWMC.