For Americans who view the stock market as a spectator sport, it can be entertaining to watch TV’s financial pundits roll up their sleeves and start waving around at charts that show large, downward-pointing arrows when stock prices take a dip.
But for investors who go from celebrating their portfolios one day to crying over them the next, a stock market downturn is no joke.
There’s no doubt that investing hard-earned money into a market that’s largely out of individual control comes with some risk, and market volatility is actually a sign that things are working the way they’re supposed to. But logic can quickly take a back seat to panic when stock prices take a nose-dive.
The good news? It’s possible to create a proactive, anticipatory financial plan that can help investors prepare for, get through and even come out the other side of a market decline with flying colors. Here are some strategies for riding — and surviving — the roller coaster.
Image Credit: g-stockstudio/iStock.
Why does the stock market go bear?
When the good times roll and stock prices are way (way) up, many people picture the stock market like something out of “Wolf of Wall Street.” It’s referred to as a bull market, and it’s always the ideal — so much so that artists erected a giant bronze bull sculpture in front of the New York Stock Exchange.
But when the major stock indexes fall by 20% or more from their most recent peak — and stay there for two months or more — it’s called a bear market. It’s not a new or unexpected idea, but it’s safe to say that we’re not likely to see a grizzly sculpture in downtown NYC any time soon.
It’s also never easy to predict what might send investors into sell mode. The reasons could be based on economic fears or uncertainties, such as recent worries about a trade war between the U.S. and China, a change in the federal interest rate, or something completely unrelated to business such as a terrorist attack, public health concerns, or a natural disaster.
The stock market, for the most part, seems to follow a “perception is reality” view of the economy where everything — regardless of its source — is connected.
For a real-life, 21st-century example, consider that Peloton ad from December 2019 — you know the one.
It went viral on social media and caused a public outcry, and the company’s stock dropped to the tune of $1.6 billion in short order. This stock has since rebounded because of the demand for in-home workouts. But, this example shows the volatile nature of the stock market.
And while that’s an individual instance, the resulting supply-and-demand effect is relatively easy to expand to an entire industry or even the U.S. economy as a whole.
Image Credit: monsitj / iStock.
Why volatility is a good thing
Reward doesn’t usually come without some risk, so those periods of sell-off and correction are seen by many investors as a necessary evil. But just how much fluctuation is normal?
That’s a loaded question.
The benchmark for the U.S. stock market is the S&P 500, which was officially opened for trading in 1957 as an index of the country’s 500 leading companies. Since then, it has averaged an annual return of around 7% (based on the inflation-adjusted annual return of the S&P 500 since 1926), and many investors see it as the bellwether for the economy at large.
The S&P 500 has experienced at least 23 corrections over the past three decades, meaning a decrease of 10% or more. Eleven of those were drops of more than 20%, leading to bear markets. On average, the larger drops have happened every five to 10 years or so, with smaller fluctuations in between.
The largest drop in recent history was 57% in October of 2007, brought about by the subprime mortgage crisis and eventually leading to a recession. But the good news is that even that huge decline in stock prices eventually recovered. In fact, every market decline in history has done the same.
Image Credit: DepositPhotos.com.
How to plan for a market downturn
Some smart financial planning strategies can help keep outlooks (and outcomes) on the up-and-up, no matter what happens on the trading floor.
Image Credit: DepositPhotos.com.
1. Keeping your eye on the ball, and the long haul
In poker, there’s a phrase called “going on tilt”— a player loses a large stack of chips and then loses their cool. Investors can go on tilt, too, if they freak out and sell everything the moment there’s a sign of trouble.
Both versions are driven by emotion versus strategy, and both can lead to bad decisions and missing out on big opportunities.
And the media may not help, especially when financial commentators take to the airwaves armed with speculations, theories and advice. When faced with a lot of hype, one of the smartest things an investor can remember is that no one has a crystal ball in their arsenal.
It can also be smart to keep in mind that just as no one can predict the market, most experts aren’t so great at timing their investments, either. In fact, the passive S&P 500 has outperformed active fund managers — whose sole job is to outperform the market — for nine years in a row.
Some experts even recommend investing in a down market, especially in a long-term retirement plan like a 401(k). Why? Because if one thinks of a lower stock price as being on sale, any elective salary contributions have the potential to go further.
Image Credit: g-stockstudio/iStock.
2. Evaluating your asset allocation
When it comes to creating a balanced portfolio, whether it’s a personal portfolio or a retirement plan such as a 401(k) or IRA, diversification tends to get all the attention. But it has a first cousin as well — called asset allocation — that is just as important for aiming to minimizing risk.
The two terms are often used interchangeably, but here’s the difference: Diversification is ensuring that a portfolio is well-balanced across one type of asset class — stocks, for example.
A good financial adviser may suggest a mix of large-cap funds, mid-cap funds, mutual funds, indexes and perhaps individual stocks for diversification. Asset allocation, on the other hand, is investing in not only stocks, but also other asset classes, such as commodities, bonds, cash, or real estate.
Asset allocation can help protect against a market downturn because where one class of assets might go down, another might go up. How assets are divvied up depends on financial goals, risk tolerance, investment timelines and past performance. Bonds, for example, can be one smart way to balance out stocks because they generally have an inverse relationship with stocks.
And while they operate more like a loan and don’t carry the explosive growth potential that stocks do, they are one way to add stability to a portfolio, especially as an investor reaches retirement age.
Likewise, commodities such as precious metals, oil, or farm futures tend to work in opposition to the value of the U.S. dollar — when one goes up, the other goes down.
All the choices — and the choices within the choices — can quickly get overwhelming for average investors. One easy way to simplify is to invest in mutual funds or exchange-traded funds (ETFs), two types of investments that come pre-packaged with a mix of stocks, bonds and other assets.
Since mutual funds are actively managed by professionals, they’re likely to incur fees between 1% and 3%. ETFs, on the other hand, are often either managed by robo advisors or not managed at all, and can be traded with low or no commission fees.
Image Credit: iQoncept / iStock.
3. Looking for value stocks
Stocks are generally classified as value (also called defensive) and growth. The growth stocks are the up-and-coming, risky ones that trade above market averages, and value stocks are the old, faithful, long-standing companies that tend to trade lower than average.
Generally speaking, value stocks tend to weather market fluctuations better than their growth counterparts because of their steady growth history or ever in-demand products. They can include companies like utilities, health care organizations, or consumer staples.
Finding a true value stock can involve quite a bit of digging — and math. Here’s our look at how to evaluate individual stocks before you buy.
Image Credit: AUDINDesign / iStock.
4. Determine your time horizon
In investing terms, a time horizon is the amount of time someone plans to hold on to a stock or bond in order to meet a specific goal.
For young investors with time on their side, a personal portfolio or retirement account that’s heavy in high-risk growth stocks could be a smart investment, because they have the ability to go through the downturns and still have time to recover — not to mention a long time to take advantage of compounded interest.
As someone moves closer to retirement, however, and the time horizon becomes shorter, experts often recommend moving money over into more stable investments, such as bonds or value stocks.
The reason is simple: A market correction when someone is only a year or two from retirement could put a serious dent in their financial goals and maybe even force them to re-evaluate leaving work.
Image Credit: DepositPhotos.com.
5. Shoring up your savings-vs.-spending strategy
If a decline in stock value could negatively affect a portfolio, one alternate strategy to consider could be to invest in cash instead. A good rule of thumb is to have an emergency fund stashed away that covers three to six months of living expenses, and it’s not just to have on hand in case of a job loss.
Recent reports show that around 27% of Americans borrow from their 401(k) plans before reaching retirement age.
It’s a decision that already incurs a penalty for withdrawing the money early — and if that need arises when the fund is already on the low side, the losses could be significant. Having a solid cash account on hand could eliminate that need.
The time horizon comes into play here as well, where cash reserves could be the potential difference between staying on track to retire during a downturn and having to work until the markets recover.
One option at retirement age is having two years’ worth of expenses available in cash, and a portfolio that’s 60% stocks and 40% bonds (one that’s likely to recover within two years after a bear market).
Image Credit: designer491 / iStock.
6. Remaining open-minded (and open-ended) about work
Considering all options to ward off a market slump includes taking a look at employment, both current and future, with an open mind.
If retirement calculators aren’t coming up with numbers that will be workable in a set timeframe, what changes are on the table? If it’s possible, a few extra years of income, especially during a bear market, can help build up a nice cash safety net (not to mention postponing and boosting Social Security benefits).
That doesn’t have to mean staying in a cubicle a minute longer than necessary, though.
For hustlers of all ages, side gigs have quickly trended as a way to add to income while enjoying life at the same time. And for investors closer to retirement age, leaving one career for another might not only bring in more money, but also fulfillment.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA/SIPC. The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Image Credit: iStock.AlertMe