It’s inescapable. Central banks have driven rates into the ground. According to the WSJ, there is more than $11 trillion of debt with negative yields.
Lower yields in turn drive up asset prices. Stocks seem to break new highs on a regular basis. There’s talk of real estate bubbles forming again. It’s not surprising. With cash earning nothing, investors move their liquidity to other assets (e.g., dividend paying stocks) for yield.
Eventually the music will stop and investors will head for the exits. While I don’t know when it will happen or what will be the final straw that sets panic in motion, a significant correction will occur.
Here are several ways to prepare your portfolio for the inevitable.
1. Recognize Bear Markets are a Reality
In his book The Road Less Traveled, M. Scott Peck observed that life is difficult. But he didn’t stop there:
Life is difficult. This is a great truth, one of the greatest truths. It is a great truth because once we truly see this truth, we transcend it. Once we truly know that life is difficult-once we truly understand and accept it-then life is no longer difficult. Because once it is accepted, the fact that life is difficult no longer matters.
One can apply this to investing. Stock markets crash from time to time. If we recognize this in good times, we prepare ourselves for the difficult times.
The timing of a market correction is sometimes surprising. The crash of 1987 comes to mind. But the fact of a down market should never take us by surprise.
2. Check Your Asset Allocation
It’s been said that the more you sweat in peace, the less you bleed in war. The same is true with investing. It’s during a bull market that we should ensure that our asset allocation is both realistic and aligned with our financial objectives. The goal is to have in place an investment plan that we can stick with during a down market.
Here the primary focus is on the stock and bond allocations. This critical decision drives long-term returns and volatility more than any other asset allocation decision. The worst time to make significant changes to an investment plan is when equities are in free-fall. For those with at least 10 years left before retirement, an asset allocation of at least 70% in stocks is ideal. As you near retirement, the stock allocation often goes down. Even in retirement, however, keeping at least 50% in stocks is usually a good idea. Remember that at age 65, retirees are still planning on a 30 year retirement.
3. Examine Each Fund
Beyond asset allocation, we should examine each individual mutual fund or ETF we own. This is particularly true if you invest in actively managed mutual funds. A combination of high expense ratios and a falling market often cause people to sell actively managed funds at the wrong time. In fact, studies have found that investors in index funds were more likely to stick to their investment plan in difficult times then those who invest in actively managed funds.
4. Follow the 5-Year Rule
A good rule of thumb is not to invest any money in the stock market that you’ll need over the next five years. This is particularly important for those who are in retirement and relying on their investments for daily expenses. The goal here is to avoid a situation where you have to sell stocks during a bear market in order to meet living expenses.
This rule is difficult to follow today given the extremely low yields in the bond market. But given the relatively high prices of equities, it’s an important rule to follow. With at least 5-years worth of expenses out of the market, an investor is more likely to weather a bear market knowing their immediate needs are taken care of.
5. Stay Out of Debt
This last factor may surprise some because it has nothing to do with investing directly. It’s here that we take a holistic approach to our finances. You’ve probably worked through a questionnaire from a brokerage firm that’s designed to assess your appetite for volatility. These questionnaires tend ask questions such as what you will do if the stock market falls by 20%. What these questionnaires fail to address is the amount of debt that you have.
Why is that important? In my experience, those with little debt relative to their income and assets are more likely to weather a bear market. In contrast, those with a lot of debt relative to their income and assets are in a less stable financial position and more likely to flee the market in fear.
I put the question of how to prepare for a stock market crash to the Dough Roller Facebook community. There were many helpful responses. One member named Ryan offered sage advice:
My two cents would be that there isn’t any preparation (in terms of moving money) that needs to be done if you have already chosen your investment strategy. You simply have to ride out the lows to get to the highs. The market can’t be timed (let alone twice) so don’t try to sell at the top then buy at the low. Market crashes are part of the cycle and are unavoidable. That said, I think psychologically is where people could benefit from preparation. Simply educating yourself on market cycles and reading literary works (The Simple Path to Wealth by JL Collins) of much smarter people will keep your emotions in check better during a downturn than if you didn’t take these proactive steps.
The key is to prepare now for a falling market. In my case, I assume that the value of my portfolio will be cut in half during the next bear market. While that is extreme, it follows the old adage, prepare for the worst and hope for the best. - Forbes
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