Preparing for the Next Market Crash
It’s the scenario investors dread: The stock market plummets and along with it, the value of their accounts. Panic ensues as investors demand their advisors sell out of the market to stop the bleeding. Any competent advisor will tell you that’s usually the last thing you should do. They are right.
For one thing, investors may end up selling at the worst time, locking in losses they may never recoup. Investors who sell their positions are then faced with the decision of when to buy back in, likely missing out when the market rebounds—causing long-term damage to financial goals. Instead of selling out of the market and trying to figure out when to reinvest, or obsessing about what action to take, try a different approach. Here are four routes to consider:
Do nothing. It’s essential to understand that the market will experience corrections —as well as recoveries—over time. According to data from BTN Research and Fidelity Investments, there have been 32 bear markets since 1900 (defined as a 20 percent decline or more). The most recent U.S. bear market occurred in 2007-2009 when the stock market dropped over 50 percent. Investors who stayed the course recovered, as the market surged over the next several years. That’s not an outlier. As this Bloomberg article points out, double-digit returns in the market are “normal” rather than the exception. Over the past century, the market has recorded gains in roughly three out of every four years. Therefore, develop an asset allocation strategy you can stick within all market environments, and stay the course. Avoid obsessing over daily market movements. The more you can shield yourself from the discomfort of the moment, the less likely you’re going to overreact or make a decision you’ll regret later.
Consider low-cost investments. Since (often significant) market corrections are a regular part of investing, take steps to prepare for them in advance. For instance, consider choices such as low-cost passive index funds. Since these funds track indexes, there’s virtually no trading and selling involved, keeping costs and turnover low. That means index funds are among the most cost- and tax-efficient investments available. They’re also inexpensive. According to the Investment Company Institute’s 2017 Fact Book, the average expense ratio of actively managed equity mutual funds in 2016 was 0.82 percent. By comparison, average index equity mutual fund expense ratios were a relatively slim 0.09 percent—or 89 percent lower! That means more money in investors’ pockets who avoid overpaying for expensive funds.
Avoid active management. Investors should also be wary of marketing tactics from active managers who tout their ability to outperform markets and generate “alpha.” Did you know that simple statistical regression analysis can debunk even the most successful active managers? It’s true, and even when managers generate “alpha,” no one knows if it’s because of luck or skill. Research by Eugene Fama of the University of Chicago and Kenneth French of Dartmouth’s Tuck School of Business concluded that “Even if no [active] fund manager is good or bad, many funds will do well and many will do poorly purely by chance.” That doesn’t stop managers from selling you on their ability to know more than the millions of investors in the marketplace. Active managers have higher costs, higher turnover, tax-inefficient strategies, and are rarely able to deliver on their promise of providing superior “risk-adjusted returns.” The evidence is overwhelming.
Diversify your portfolio. This Vanguard article lists many vital points emphasizing the importance of diversification, including that investment success is mostly determined by the long-term mixture of assets in a portfolio, and the more diversified, the better for portfolio success. Further, since one cannot reliably predict what area of the market will outperform, it’s best to own the entire market, which is now more accessible than ever and at historically low costs (see index funds above). Not only does diversification help investors capture global markets to gain returns wherever they occur, but it can also reduce risks that offer no reward, prevent investors from missing opportunities, reduce portfolio volatility, and help take the guesswork out of investing.
Ultimately, when it comes to dealing with down markets, the guidelines are straightforward and easy to implement. First, don’t be shocked when market corrections occur, because they routinely do. To prepare, look to low-cost investment choices and avoid expensive active managers. Stay diversified and own the entire market. A long-term disciplined approach to investing can help prevent mistakes and keep you in your seats during the next market downturn. We know a slump is coming, so prepare your portfolio by implementing the steps above to maximize your chances of success.