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How to Prepare for a Market Correction

We have a confession: When creating this blog, we considered timing the market. We tried to determine in advance the ideal time to post it. If we waited too long, we risked publishing after a correction; if we published too early, it could get lost in the noise from market gains.

October and December of last year seemed like opportune times to publish as markets became volatile. But, markets dipped quickly and rallied just as fast to record-breaking highs.

Attempting to publish a blog based on market conditions, like all market timing, is difficult. As investors that reject the notion of market timing, the irony isn’t lost on us. We think part of our responsibility as investment advisers is to educate investors, which is why we planned to publish this blog regardless.

After a bull market that is nearly six years running, a correction or bear market is likely overdue. That’s why preparation is essential. And, our experience with this blog leads us to the first step on how to prepare for a market correction:

Don’t believe you can time a market correction

You don’t know how the economy will perform tomorrow, what world leaders will do, or if central bankers will raise or lower rates. Therefore, it’s highly unlikely you’ll see a correction in advance and make the right decisions to outperform the market.

When investors try to predict market movements, they are usually wrong. This includes many investment professionals. A 2014 Standard & Poor study found only 3.78% of 687 actively managed funds remained in the top performing quartile over a three-year period. The lack of persistent performance indicates some active managers are occasionally lucky, but few if any are skilled. Don’t rely on luck to get you through the next market correction.

Accept market corrections, don’t expect them

Market corrections are relatively common. Since 2009, there have been 14 corrections of 5% or more through October 9, 2014. Major market corrections of 30% or more like 2008 are rare; only five have occurred since the 1920s.

You have to accept the risk of a loss for a chance for a reward. But, if you start to expect a market correction you may fall for confirmation bias, the tendency to only notice information that confirms your opinion. This behavioral response could fool you into making poor investment decisions. You should ignore short-term trends and plan for the long term.

Maintain a broadly diversified portfolio

Diversification can reduce the impact of market swings on your portfolio by balancing your performers and underperformers. You may not receive extraordinary gains, but you will likely avoid dramatic losses. Steadier returns can decrease the chance you panic.

Additionally, exposure to a variety of stocks and bonds increases your sources of potential returns. A diverse mix of various stocks and bonds can perform better as a whole than each individual asset class.

Understand the reward from discipline

Your investment strategy should consist of an asset allocation based on the needed risk and expected return to meet your financial objectives. The right asset allocation for you should also have an amount of risk you’re comfortable with at all times.

The discipline to stay with your strategy can be rewarding. A study by the Employee Benefit Research Institute and the Investment Company Institute found workers who stayed in their 401(k)s from 2007 through 2012 had an average balance that was 67% higher than the average of those who abandoned their plans. When you panic and sell, you risk missing out on the proceeds of the market recovery.

Discipline isn’t easy. It means returning your assets to their original target levels by rebalancing – trimming some of what is up and buying some of what is down. Just remember, like a train entering a mountain, there’s light at the end of the tunnel as long as you keep moving.

Have bonds in your arsenal

Staying the course may be easier when you’re young, working and earning a salary. What if you’re near or in retirement? As you drawdown your portfolio for retirement expenses, the decumulation phase, you may have a shorter time horizon. A steep market decline could adversely impact your portfolio’s viability as an income source.

This is why you should own bonds. Bonds are generally the ballast of your portfolio, providing stability and capital preservation. During a bear market, they can act as gunpowder to fuel your portfolio income stream. If stocks are down while bonds are stable, rebalancing may allow you to use the proceeds from trimming the bond side plus your dividends to raise your desired withdrawal amount, depending on your income needs. Rebalancing during these conditions is also an opportunity to essentially buy stocks on sale.

We can’t control nor predict when the next market correction will occur. (The ability certainly would have helped us decide when to publish this blog.) That’s why it’s better to prepare and commit rather than guess and react.