How to weather a stock market correction
When stock prices are falling, some investors find themselves trapped in a vicious emotional cycle: fear of losing money often leads to anger, and anger can lead to a quick, poorly planned decision. But investors who have taken steps to prepare their portfolios for occasional market drops may be better equipped to manage their emotions when stock prices head south.
A stock market correction is defined as a time when major market indexes drop between 10% and 20%. Declines greater than 20% are considered to be bear markets. Since 2000, stocks have experienced a correction several times, and there have been two bear markets.
Sizing up your portfolio
If confronted with a market correction or bear market, take time to review your portfolio. Are all your investments in stocks or stock mutual funds? Do you own just one stock mutual fund? Have you invested in only a few high-flying stocks?
Remember, all investments involve risk. As a long-term investor, you should not focus on short-term price changes. But you can also make the long journey a little more enjoyable by considering a few steps during a market correction. Here's a short list of some risks you may face as a holder of stocks or stock mutual funds, and some ideas about how to potentially reduce the chances that your portfolio suffers a big loss.
Limiting Risks
Market risk is common to all investments. If stock prices fall, market risk says your stocks or stock mutual funds are likely to drop in price as well. You may reduce market risk to stocks by allocating part of your portfolio to other assets, such as bonds or bond mutual funds and Treasury bills or money market funds.Footnote 1 When stock prices decline, it's possible that a rise in your bond or money market investment will help cushion the fall. Investment in a money market fund is neither insured nor guaranteed by the U.S. government, and there can be no guarantee that the fund will maintain a stable $1 share price. The fund's yield will vary.
Another risk to avoid is underdiversification. If you only own a couple of stocks, you are extremely vulnerable if one suffers a big decline. Experts recommend that stock investors hold at least eight stocks. If one stock falls sharply, the drop will likely have a limited influence on your portfolio. Also, it's important that each of the eight stocks be in a different industry group. Owning eight computer-related stocks will do you little good when the prospects dim for the computer industry. Underdiversification is also a risk with mutual funds. If you own only one aggressive growth mutual fund, it's likely to fall sharply if the S&P 500 drops by more than 10%. You can temper the risk by holding a few stock mutual funds with different investment objectives. Diversification does not protect an investor from potential loss.
Volatility risk is a consideration, but it generally is not as important to an investor with a long-term time horizon. Someone who is investing for retirement in 30 years should not be too concerned if the investment bounces around from one day to the next. What is important is that the investment continues to perform up to expectations. You can cut volatility risk by investing the money you may need in the next five years in a more conservative investment. You may want to consider being more aggressive with the money you earmarked for use in 15 to 20 years.
Missing the Top Months
Missing the market's top-performing months can prove costly. This chart shows how an investment could have been affected by missing the market's top-performing months over the 20-year period from January 1, 2003, to December 31, 2022. For example, an individual who remained invested for the entire time period would have earned an annual return of 9.80%, while an investor who missed just five of the top-performing months during that period could have earned only 7.04%.
Source: ChartSource®, SS&C Retirement Solutions, LLC. For the period from January 1, 2003, through December 31, 2022. Based on total returns of the S&P 500 index, an unmanaged index that is generally considered representative of the U.S. stock market. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. Past performance is not a guarantee of future results. © 2024 SS&C. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. (T9B)
Consider value stocks
Understanding downside risk is critical. Owning a stock that drops 50% in value can have a devastating impact on a portfolio. The next stock you own would have to climb 100% to offset that initial decline. You can potentially cut downside risk by avoiding stocks that trade with high price/earnings (P/E) ratios. When the stock market does retreat, these expensive stocks often fall the furthest. Consider looking for issues with more reasonable P/E ratios — often called value stocks — that pay solid dividends. Mutual fund investors should look for funds that invest in similar types of stocks.
Finally, investors need to be aware of liquidity risk. If you invest in a stock that "trades by appointment only," you may get a low price if you are forced to sell the issue on short notice. You may be able to reduce liquidity risk by focusing on large, actively traded companies such as the issues included in the S&P 500. Generally, mutual fund investors do not have to worry about liquidity risk. But if you invest with a small mutual fund company, make sure you understand the rules about withdrawing funds before sending money. Upon redemption, shares in a mutual fund may be worth more or less than the original principal invested.
Total Annual Returns for the S&PFootnote 2
If the prospect of the market falling scares you, consider this chart. In the past 25 years, the S&P 500 has recorded only six years of negative returns, and only once has the index finished on the negative side for three consecutive years. Keep in mind that investors cannot directly purchase an index. Index performance assumes reinvestment of dividends, interest and other investment proceeds, but does not account for an fees, commissions, taxes, or expenses incurred by actual investments. Past performance does not guarantee future results. (T2C30).
A healthy market decline
It's important to remember that periods of falling prices are a natural and healthy part of investing in the stock market. Investors who are concerned about this risk can consider strategies to help them limit their overall investment risk position.
One risk that some investors may be exposed to is the risk of falling short of reaching a long-term financial goal. Investing too conservatively may contribute to not reaching an accumulation target. Remember that despite several down cycles, stock prices have historically risen over longer time periods. (Past performance, however, does not guarantee future results.)
Footnote 1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although most funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.
Footnote 2 Source: ChartSource
®, SS&C Retirement Solutions, LLC. Based on calendar-year returns from 1998 to 2022. Stocks are represented by the S&P 500 index. The average return counts only full calendar years. Past performance is not a guarantee of future results. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. It is not possible to invest directly in an index.
© SS&C. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions.
The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.
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Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.
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