How to Limit the Impact of Major Market Corrections
Less than a year ago we saw first-hand how a significant external force (in this case the COVID-19 pandemic) could trigger a major market correction. Unexpected non-financial factors such as wars, political upheaval, terrorism and natural disasters can wreak havoc on global financial markets. But thankfully, these disruptors tend to be relatively short-lived.
As last February and March perfectly demonstrated, resulting declines can be precipitous—but often, so too is the subsequent recovery. The S&P 500 dropped 8.4% in February and then plummeted another 12.5% in March with lockdowns shuttering much of the economy. Yet over the next three months, the index (+20.54%) recovered all those losses and subsequently went on to set new all-time highs—finishing the year up 16.3%.
Similarly, when the stock market finally reopened after the September 11 terrorist attacks two decades ago, within five trading days the S&P 500 Index had dropped 11.6% and the Nasdaq had fallen 16%. Within a month’s time, however, both indexes had regained their pre-9/11 price levels.
In both cases, despite the profound human and economic costs associated with these events, investors quickly came to view them as temporary external impediments. And because financial markets are forward-looking, once the initial shockwave was absorbed, it didn’t take long for a recovery to ensue. But what happens when corrections are driven by internal rather than external factors?
A Longer Road to Recovery
When corrections are the result of fundamental internal economic and market changes such as rising inflation, monetary and tax policy, or cyclical overvaluation of prices relative to earnings, the resulting recession and recovery tend to be more prolonged—a matter of years rather than months.
During the 17-month bear market period from October 2007 to March 2009, the S&P 500 lost nearly 50% of its total value. Although it took a full four years for the index to recover those losses, in the decade that followed the post-financial crisis bottom on March 9, 2009, the market ultimately went on to generate a cumulative return in excess of 400%.
The consistent theme in every one of these examples, however, is one of recovery. We may not be able to predict when a correction will happen, how deep and prolonged it will be, or the duration of the eventual recovery. But we can be historically confident that at some point in the future the market will again be setting new highs.
Mitigating Your Risk
So, what should investors do? The easiest answer is to do nothing—to not panic when the market swoons and simply allow time to be your greatest ally. There are, however, a variety of effective strategies that can help reduce your investment risk and help you better prepare for whatever the market may have in store.
Rebalance your investment portfolio: Over time, especially during an extended market run-up, your asset allocation can shift drastically from its target. Because of the far more substantial appreciation of stocks relative to bonds, a typical 60/40 moderate risk portfolio (60% stocks and 40% bonds) that you and your advisor created a decade ago may today have shifted to a very aggressive 80/20 allocation. By periodically rebalancing, you can keep your investment risk in check and lessen the impact of future corrections. (Note: Investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future results.)
Dial back risk when warranted: Have you achieved important goals such as funding your children’s education, or are close to reaching other goals like saving enough for retirement? If so, you can afford to be more conservative with your investments. Similarly, if retirement is close on the horizon (within three years) you should also consider reducing your overall portfolio risk as the market may not have time to sufficiently recover before you begin drawing down your assets for income.
Consider gifting highly appreciated stocks: It’s a strategy that accomplishes two goals at once; it supports the charitable organizations and causes that you care about, while at the same time helping to rebalance your portfolio by reducing your stock holdings. And it does so without triggering any capital gains and providing you with a charitable tax deduction for the full fair market value of the stock.
Keep bond maturities shorter: Given the current low interest rate environment (and the potential for rates to rise in the future) look for higher coupon bonds with shorter durations rather than longer maturity government bonds. Talk to your advisor about possibly increasing your allocation to high yield corporate bonds and/or floating-rate bonds where interest rates adjust (often monthly or quarterly) to help lessen the impact of any future rate increases.
Talk with your advisor about more sophisticated strategies: Depending on your individual circumstances and needs, your advisor may be able to suggest additional risk mitigation strategies to further protect your wealth.
The market has come a long way in the decade-plus since the bottom of the Great Recession. Nobody knows when the next leg down will occur or how long it will take for the subsequent recovery. But there are ways that you and your financial advisor can help better position your portfolio to weather any storms that may be on the horizon.
Gary K. Liska may be reached at 310-712-2323 or seia.com.
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