Are You Prepared for a Market Correction?

There's never a bad time to ensure you have a storm management plan for your portfolio

John F. Wasik 29 September, 2014 | 8:00AM
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When a bull market is roaring, preparing your portfolio for a correction or bear market might seem like closing the storm shutters on a sunny day.

But there's never a bad time to batten down the hatches for rough weather—or at least ensure that you have a storm management plan for your portfolio for whenever the market takes a turn for the worst.

I surveyed some financial planners to find out what they are doing to prepare their clients for blustery markets. Although you don't need a financial adviser to do any of this, you will want to take a page from their book by building in some protection and sticking to an investment policy statement that lays out your goals, expected rate of return and risk tolerance.

For Bonnie Ashby Sewell, a certified financial planner and principal with American Capital Planning, a good protection plan will focus on both short-term cash needs and long-term growth. That way, if a market correction comes along her clients won't come up short. Protection is the top priority and cash is king for retirees—meaning enough to cover one- to five-years' worth of spending needs.

Cash also enables investors to pursue new opportunities. What if the market goes down and you want to go bargain-hunting? What if that piece of land you've coveted comes on the market? What if you want to invest in a business? Cash enables these transactions in tough times.

"If you needed cash in the recession and had it, you didn't need to sell," Sewell says. "If you had cash and didn't need it, you might have been able to snap up real estate at (now) gone prices and retired on those properties. In my view, there is always a good reason to have cash; it's not sexy, hard to sell to 'smart money people,' but quite useful in real life."

On the investment portfolio side, Sewell stresses the tandem concepts of "risk capacity" and "risk required." The first measures how much you can afford to lose in a downturn, the second how much risk you need to take in order to beat inflation.

Inflation, Sewell notes, is a perennial bogeyman. Although the cost of living has been pretty flat—growing at around 2% recently—it could easily climb if the economy heats up. That means taking some risk in the stock market to keep up with the cost of living.

How much risk? It depends upon what percentage of stocks you want to hold. A good adviser can show you how a portfolio might perform under various scenarios.

Sewell asks her clients to take a "tummy test" to see how uncomfortable they will be at various loss levels. Can you stomach a 10% decline? 20%? How about 37%, which is what happened in 2008?

"It's not that hard to blow up a financial plan," Sewell adds. "Most people haven't over-saved and don't understand how long they're going to live and how much it will cost."

Stress-Testing Your Portfolio 

Like many financial planners, Sewell uses software to see how her portfolios might perform in a downturn. This "stress test" is essential when working with a good adviser, but even if you aren't getting hand-holding services, look at the funds you own. How did they do in 2008? What was their "drawdown," or the amount of money lost during a down cycle?

Ben Hockema, a certified financial planner with Deerfield Financial Advisors, asks clients about past behaviour to do an initial stress test.

"We determine risk tolerance a number of different ways," Hockema says. "One of the first things that I talk to new clients about is how they have handled various market events in the past. Did they change their asset allocation in 2008? Why? If they are saving money, did their savings rates change (up or down) during 2008? What have they done since then?"

With risk tolerance, past is prologue. What did you do to deal with 2008's gut-wrenching decline? Did you stay the course? Did you pull out? When did you get back in? If you had a plan, did you change it?

"There is only so much that an adviser can figure out about a client's risk tolerance from surveys, hypothetical conversations, etc.," Hockema adds. "The most important piece is actual evidence based upon the client's own reactions to past events."

While not everyone has the luxury of having the guidance of a financial adviser, you can take concrete steps to prepare for a bear market.

Review your portfolio allocation to see if it can weather a storm. That means checking the amount you have in stocks, bonds, property and other investments; which vehicles will get hit hardest; and the worst-case scenario. Although every bear market is different, reviewing how those investments did in 2008 and 2011 can give you a feel for how they perform under pressure.

How much cash do you need on a short-term basis? This involves drafting a cash-management plan. What will you need to cover expenses over the next three to six months? If retired, project your cash needs over a longer period of time.

How is your income portfolio insulated? Don't forget that bonds can swoon when interest rates rise. Are you prepared for a bear market in bonds after 30 years of a bull market due to declining rates? If you're holding individual bonds to maturity and not intending to sell, the loss of value may not concern you but bond funds are prone to declines in value when rates climb, with the most sensitivity seen in long-term maturity and high-quality bonds.

The worst thing you can do is become complacent or react to the market in real time, which often results in bad decisions when things turns south. You still need to think long term and plan for it. That means taking an honest look at what it will cost to live a long life, along with ups and downs in your portfolio.

John F. Wasik is a freelance columnist for Morningstar. The views expressed in this article do not necessarily reflect the views of Morningstar.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

John F. Wasik  John F. Wasik is a Morningstar columnist and author of 13 books, including The Audacity of Help: Obama's Economic Plan and the Remaking of America (www.audacityofhelp.net).

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