It seems that every day lately, someone in the media is talking about an inevitable correction in the stock market of 10-20% or more. If and when a correction is going to come is anyone's guess, but the experts do make some good points, like no major pullbacks since hitting the financial crisis lows in 2009. Whether or not we see a big drop in the market soon, it is a good idea to take time to learn how to play defense in case things go sour.
Cash is king
With a strong possibility of a correction in the near future; it is a good idea to keep some cash available to take advantage of opportunities that present themselves. Looking back, don't you wish you had more cash to buy stocks in March 2009?
Why is it so important to have some of your money in cash? For example, let's say one of the holdings in your portfolio that you love for the long haul drops by 25%. If your portfolio is fully invested, you have no choice but to ride out the storm. However, if you have some cash on the sidelines, you can take advantage of the situation and add to your position at the newly discounted share price.
If your portfolio is 100% invested right now, that doesn't mean that you need to sell something to free up cash. However, if this is the case, it might be a good idea to leave any new deposits on the sidelines for the time being. Besides, valuations are pretty high right now, which makes it important to be pickier than usual about what you buy.
Low volatility wins in corrections
In general; you want rock-solid companies in your portfolio when a correction comes around. If the overall market drops by 10%, the effect is usually much worse on volatile, speculative stocks. However, if you invest in solid, time-tested companies, the pullback in share price might not be so bad.
For example, the S&P dropped by almost 58% from its peak during the financial crisis. The more volatile stocks across the market lost much more than that amount, but some of the more "stable" companies fared much better. For example, Wal-Mart's losses were limited to 28%, and ExxonMobil lost 40% of its value at the bottom.
While it's not possible to time the market (and I don't recommend trying), it is pretty certain that a correction will happen eventually. Your defensive stocks should help maintain the value of your portfolio, which will leave you with plenty of money to capitalize on the big drops in the more volatile stocks on your radar.
Invest with the best
For an excellent example of the type of stocks that do well in a correction, take a look at the stocks held by Warren Buffett's Berkshire Hathaway (NYSE:BRK-A). Included in the portfolio are banks, insurance companies, food producers, construction companies, retailers, and more. All of the stocks that Warren Buffett buys meet two very basic criteria.
First, each company Buffett buys is engaged in a business that will be needed for years to come. Just looking at the types of businesses I mentioned above, people will always need a safe place to put their money, insure against bad things happening, build homes, and buy goods and services.
Once it's established that the business will withstand the test of time, he looks for a competitive advantage within the industry. It is pretty easy to make a case for every stock owned by Berkshire that something sets them apart from the competition.
For these reasons, Berkshire is an excellent, diverse stock that should deliver great returns for years to come, and should allow you to rest a little easier if things go bad in the market.
The secret of truly successful investors
One thing that sets the most successful investors apart is how their portfolios perform during the bad times. Consider this: if your holdings drop by 50% in one year, you'll need to experience gains of 100% just to get back to even!
Berkshire's portfolio doesn't beat the S&P during every year of growth. In fact, the company's returns have lagged the S&P in four of the last five years. However, during the past half-century, the S&P has had 11 losing years. Berkshire beat the index's returns in every single losing year, and that has made all of the difference. The same strategy could help you come out of a correction in great shape!
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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.