Preparing For The Next Market Downturn: Is It Time For An Investing Fire Drill?

The stock market has been hot lately! From January 2010 through December 2020 the S&P 500 Index has gained over 322%! It’s easy to be a stress-free investor in this type of market.

BUT – when things get too hot they sometimes catch on fire. Is it time for an investing fire drill?

Let’s talk about it now, before the next stock market downturn.

What Is A Market Correction?

A correction is defined as a drop in the stock market’s value of 10% or more. These corrections happen every 2-3 years on average. Just because we haven’t had a correction in a few years doesn’t mean we’ll see one this year. Or even next year. But we could.

As I’m sure you’ve heard, past performance doesn’t guarantee any future results. Just because we’ve had a great ten-year stretch doesn’t mean the next year will be good – or bad. We just don’t know for sure.

Past One-Year Returns Charted

In fact, if you look at all previous one-year returns from the S&P 500, you can see a huge swing in results. From double-digit gains to double-digit losses.

The point is, we just don’t know for sure.

Don’t Let That Scare You

Now, don’t let that freak you out. Yes, the market in any single year (or a short number of years) can be very volatile. It might go up or might go down.

Historically though the market has followed an upward trend. Even with over 120 past market corrections, the average return with dividends included has been around 10%. Of course “averages” can be tricky. But even the more appropriate compound annual growth rate (CAGR) through the S&P 500’s history has been about 9% through the end of 2018.

So, based on the past, the market has done well for investors in spite of regular corrections over the years.

In fact, here are how past returns have charted over longer periods of time. The following chart reflects past results for 10, 20, 30, and 40 year rolling return periods.

Historically, long periods of time have smoothed out returns. And the longer the investing time frame, the higher the likelihood that the average annual return will be positive.

But Do Be Prepared For The Next Market Downturn

Be prepared because corrections happen.

Sometimes HUGE corrections. Don’t forget 2007-2009. It happens.

In fact, think of this as a fire drill.

If the market gets so “hot” that it starts to “burn”, and your investment portfolio starts to decline steadily rather than rise… how will you respond? What will you do? What is your plan?

Think about it now so you aren’t surprised and operating from a sense of panic later.

How will you react if your investment account balance drops 10%? How about a drop of 30%? Based on the past, it is very likely you will experience multiple stock market downturns in your lifetime. It’s best to be prepared!

Considerations To Help Be Prepared

1. Have a diversified portfolio

If the thought of holding steady through a big drop in the market makes you nervous, be sure your portfolio is appropriately diversified.

When someone talks about “the market” they often mean the S&P 500 Index as I mentioned above. Warren Buffet has given the general investment advice: “Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all the time.”

While he’s a pretty smart guy, there are concerns with that type of investment plan’s diversification. Sure, your portfolio would have exposure to over 500 different stocks, but it would be 100% US stocks. Diversifying by adding international stocks, bonds, and other asset classes can help smooth out bumps in a portfolio.

For example, during the 2007-2009 Great Recession, the S&P 500 lost approximately 50% of its value. During that same time, US Treasury Bonds increased by about 15% in value. A portfolio that was, for example, 60% stocks and 40% bonds wouldn’t have dropped nearly as much during that bear market. Of course in fast-rising markets that portfolio wouldn’t gain as much either. So there is a trade-off to consider. A financial planner or investment advisor can help you understand an appropriate portfolio mix for your specific needs.

2. Consider your investing timeline

Another important point to consider is the timeline goal for your investments. Someone saving for retirement while in their 20s or 30s has a lot of time for a portfolio to recover. With a 30-40 year investing timeline, you will likely see multiple market corrections. Understanding this and preparing yourself mentally to hold steady during a stock market downturn can be a big help.

On the other hand, if you need access to the investment funds within a few years, that needs to be considered. Performing a large withdraw while in the middle of a correction or bear market locks in losses. As you get closer to the time when you need the money you should likely be making adjustments regardless. Common adjustments include shifting the portfolio balance to a more conservative model or holding larger cash reserves.

3. Look at the bigger picture

Someone invested in the S&P 500 for the past ten years has seen huge returns. Their portfolio is more than 200% higher today than it was at the start of 2009. That works out to around 12% annualized returns – way higher than the historical average.

Even someone who started investing right before the great recession started would be about 95% ahead.

Keep that in mind when the next market correction happens.

With a ten-year return so high, a correction of 10% still leaves your portfolio with very good returns over that period.

Don’t throw in the towel by cashing out.

Remember that the historical average of around 10% includes all the past corrections, recessions, bull markets, crashes – everything that has happened in the past.

Perform Your Fire Drill Before a Market Downturn

Think about these points. If you determine on your own (or with an advisor) that you need to make adjustments – do it now. Don’t make big decisions while in the middle of a panic situation. Be purposeful to assure your investment plan aligns with your overall financial life planning.

Then, when the market does turn south – as it is sure to do sooner or later – you’ll be prepared. You will have confidence that your portfolio aligns with your needs. You’ll know that your near-term cash needs are met and you won’t have to sell while markets are down. And you’ll be able to properly consider the bigger picture of how your investments have done in the past, and how they might perform in the future.

What’s happening “today” (or short-term) in the market should be of minimal concern or interest to the long-term investor. Be sure to have an overall plan and a “fire drill” plan in place before the next market downturn.

If You Aren’t Sure

If you aren’t confident that your portfolio is ideal for you, or that it properly aligns with your overall financial life plan, reach out to us and let’s discuss it. Our mission is to help you maximize your finances to accomplish your financial life goals. Let’s talk.