How to Prepare for a Stock Market Decline

It’s been said that investing in the stock market is like riding up an escalator while playing with a yo-yo: just because the yo-yo goes up and down doesn’t prevent it from eventually reaching the next level. But, what if we could get to that next level a little faster by shortening the yo-yo’s string?

F. Scott Fitzgerald said, “The rich…they are different from you and me.” Recent research published by the National Bureau of Economic Research (NBER) proves he was right, albeit not in the way he believed. Their study found that investors with larger holdings earned relatively lower peak returns, but they earned them consistently, with less up and down. In other words, they take less risk and know that winning in down markets is more important than winning in up markets. Let’s take a look at why this is the case and some guidance on how to accomplish it:

Downside protection

In investing parlance this simply means that losing less when the stock market declines requires less return to bounce back. Let’s take a look:

• If you have $100,000 invested in the stock market and the market declines by 10%, or $10,000, the value is now $90,000. If the market then increases by 10%, $9,000, the value is now $99,000. Equal movements of the yo-yo don’t get you back to the same level. To get back to $100,000, the market must actually increase 11.1%.
• This example shows that a dollar of protection in a down market is actually worth more than a dollar of return in an up market.

The benefit of better long-term results

Think about this: Prudential recently did a study that showed earning an extra .5% return each year during your professional career can create assets sufficient to last an extra 7 years in retirement. Protecting those earnings during market declines is one good way to attain that extra .5% each year.

Diversify

We’ve all heard we’re supposed to diversify our investments, and now we’ve seen how that benefits us, but how the heck do we do it?

1. Take your retirement accounts – 403(b), 401(k), 457(b) – and any other investment accounts you may have – IRA, Roth IRA, Taxable account – and create a list of all the mutual funds you own.
2. Determine what kind of funds you own: growth stock, value stock, small cap, large cap, bond, etc. A simple way of doing that is by entering the ticker symbol into Yahoo Finance and using their description.
3. Assemble your funds by those categories and determine the percentage of your total portfolio in each. For instance, if you own $10,000 in 2 growth funds and your total portfolio is $100,000, then you are invested 10% in growth funds.

It isn’t unusual for a new client to assume they are either very aggressively invested or very conservatively invested, only to discover when we create a total portfolio for them across all their accounts, they are actually invested just the opposite. So, now that you know where you are, you can focus on where you should be.

What mix is best for you? That depends on many factors, including your age, total portfolio and your individual goals. Here is some guidance on how to group your investments:

• Long-term income assets: This category includes core bond funds but should also be diversified within the category and possibly include high-yield bond funds, bank loan funds, Treasury Inflation-Protected Securities (TIPS), etc.;
• Growth assets: These are mutual funds that invest in companies within the U.S. stock market and should be diversified across small, medium and large companies as well as growth and value funds. There are many pieces to the stock market so the goal here is to have some that zig when others zag;
• Real Estate funds: Mutual funds that invest in real estate companies can provide further diversification as well as be a good hedge against inflation;
• International funds: Since the 1970’s, having a mix of U.S. and international funds increased one’s overall returns while decreasing volatility.

You almost certainly remember the recession of a decade ago but do you remember the pain of watching your portfolio decline when the market plunged about 50%? Trust me when I say the market will go down again – hopefully not as far as in 2008 – but it will decline one day. Shortening that proverbial yo-yo string and decreasing the impact of the decline by diversifying should help you reach that upper floor a bit sooner.

Steve Byars