Market corrections are like earthquakes in California. Everybody knows they are going to happen but nobody can predict when or where they will occur.
Take, for instance, the quake at the end of August in California’s Napa Valley, which caused billions of dollars in damages. UC-Berkeley’s Seismological Laboratory state-of-the-art early warning system, ShakeAlert, was only able to give residents a 10 second warning. ShakeAlert only predicted a ‘light shaking’, even though the earthquake had a 6.0 magnitude and was felt across the Bay Area. (Mercury News)
“A stock market correction, or pullback, is when the stock market declines 10% in a relatively short period of time. It’s a natural part of the stock market cycle.” – About
Market corrections, drops in the market that establish a new equilibrium, can be much more financially devastating than an earthquake and stock brokers would kill for the luxury of a 10 second warning.
How often do market corrections happen?
According to a report by Goldman Sachs, 5% market corrections occur three times a year, 10% corrections once a year; 15% corrections occur once every 2 years; and 20% corrections, like the one we had in 2009, about every 3.5 years. Yes a big mamma market correction is overdue. Actually, we are now in the second longest bull market in the last 80 years.
“Bull Market: A financial market of a group of securities in which prices are rising or are expected to rise.” – Investopedia
It’s not only the average length of past cycles that indicate an imminent shift in the market. There are several signs that, although harmless on their own, paint a dark picture when taken as a whole. These signs include the stockpiling of bonds by investors, a switch in growth stocks from technology to biotech, and a 10-year Treasury yield fall to 2.6%.
Related article: Why A Market Correction Now Would Be the Best Scenario For Bulls
Of course, although ultimately inevitable, the market might remain bullish for years to come. The longest bull market, which was in the 1990s, lasted nearly 8 years after all. This uncertainty is what makes market so difficult, some would say impossible, to time with any kind of precision that would be useful to an investor.
So how can you prepare for the inevitable market correction?
Although a lot depends on your current investment portfolio and what kind of investor you are, here is an emergency checklist you can work through when determining how to plan for the next market correction.
Diversify your portfolio. A well-diversified portfolio is market correction proof because it holds non-correlated assets in and out of the stock market. This means you should invest in a wide-variety of investment products that don’t usually rise or fall at the same time.
For instance, bonds usually rise when stocks drop and real estate follows completely different growth patterns and cycles. Index-based exchange-traded funds provide an efficient and inexpensive way of building a diversified stock portfolio. Investment companies like Vanguard, Fidelity, Wealthfront and Personal Capital can help you build a low-cost, well-diversified portfolio. Here’s some additional reading from our friends at Fidelity: The pros’ guide to diversification.
Stay calm. Good investing is all about controlling your emotions and staying cool under pressure. If you play your cards right, market corrections actually provide great opportunities to buy quality stocks for bargain prices.
As long as your portfolio is diversified, it will bounce back after the correction. But you could get burnt if you lose your nerve and dump perfectly good stock, just because you got caught in a runaway bear market.
Trade Less. This is good advice for any market. Every trade comes with fees and costs. Instead of trying to time the market, something not even the top investors in the world can do, buy in companies with long-term growth and hold them. It is best to invest strategically for the long run instead of falling for the appeal of short-term market-timing tactics.
There’s no way to know…
We can’t know exactly when a market correction will occur. However, from a historic perspective, a big market correction is long overdue. Like architects and zoning planners in earthquake-prone areas, plan for the worst and hope for the best by building an investment portfolio that will serve you well, regardless of the mood of the market.
Financial planning software programs, such as SigFig, Betterment and Wealthfront provide a low-cost way of building a market-correction-proof portfolio. Click here for impartial reviews on these and other investment planning providers.