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News flash: sometimes stocks go down. You have to prepare for market declines -- or else you'll be a sitting duck when they inevitably come.

As silly as that statement is, it's easy to understand how investors can forget about the risks of the market from time to time. After all, when the market moves steadily upward for months on end, without even suffering minor hiccups along the way, it can lull you into a false sense of security that stocks will always be as well-behaved as they've been lately.

Until yesterday, at least.

Defying gravity
Yesterday's 2% drop for the S&P 500 wasn't particularly remarkable in itself. With problems in northern Africa spreading to Libya over the long holiday weekend, fears of $5 gasoline and protracted tension among the oil-producing regions of the world finally led the index to take a significant tumble. Energy stocks did well, with Chesapeake Energy (NYSE: CHK  ) and Chevron (NYSE: CVX  ) both posting gains on the back of significant rises in crude oil prices.

But most of the rest of the market was down sharply, for a variety of reasons. Homebuilders Hovnanian (NYSE: HOV  ) , Beazer (NYSE: BZH  ) , and Ryland (NYSE: RYL  ) all lost 7% or more, on news that home prices fell again in nearly every major U.S. metropolitan area. Airline stocks, including Alaska Air (NYSE: ALK  ) and Delta Air Lines (NYSE: DAL  ) , declined because their businesses are especially sensitive to fuel prices, which stand to rise along with the price of crude oil. And in general, the geopolitical uncertainty led to an overall malaise that stocks couldn't overcome.

Gaining perspective
What is remarkable about yesterday's decline is that we've gone so long without one of this size. The index went more than six months without having a day where it dropped 2%. Those straight-up moves are nice for your portfolio when you already own stocks, but they can cause you to underestimate the risk in your investment portfolio.

That's why it's important for you to take a few steps back from yesterday's market scare and take a close look at your investments. There's no need for panic: A 2% drop is an ordinary event for stocks. But taking a calculated look at your risk level always makes sense, especially when bad news or other concerns make the future look less rosy.

In particular, here are a few things to take a look at:

  • Have you rebalanced your portfolio recently? If not, the fact that the S&P had doubled from its March 2009 intraday lows before yesterday's pullback means that you may have more of your money in stocks than you realize. If your overall asset allocation isn't in line with your risk tolerance, then making changes to shift some of your stock money into other investments is a prudent move.
  • Are you diversified? Making big bets on particular sectors can be lucrative when the markets are moving your way, but when they reverse, those gains can evaporate in a hurry. Moving some of your money into less volatile areas of the market can help you protect those hard-earned gains.
  • Have you made a shopping list? For months, investors who've been stuck on the sidelines have bemoaned the fact that the market would never give them a big dip to let them take advantage of bargain prices. Now the odds look much better that you could get an opportunity to buy stocks at better prices. By having your watchlist set up in advance, you'll put yourself in the best position to pounce on those deals as soon as they come.

Don't panic
Sudden market declines are scary, especially when they result from dangerous situations in the world. As a long-term investor, though, you have to remain confident that just as financial markets have gotten through past crises, they'll get through this one as well -- and those who stick with their investing plans stand the best chance to profit from them.

If you don't have a watchlist yet, start one today. My Watchlist is completely free and keeps you up to date on all your favorite stocks. Click here to get started.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger may not always be punctual, but he likes a good correction now and then. He doesn't own shares of the companies mentioned in this article. Chevron is a Motley Fool Income Investor selection. Motley Fool Alpha owns shares of Chesapeake Energy, which is a Motley Fool Inside Value recommendation. 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 Fool's disclosure policy is always right on time.

Read/Post Comments (2) | Recommend This Article (17)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 24, 2011, at 1:27 PM, choicelaw wrote:

    Walmart was on my watchlist since the begining of the year, finally got in at what should be a good price.

  • Report this Comment On March 02, 2011, at 3:27 AM, tomd728 wrote:


    Tough to avoid the quality "action center" of late and that would be the *true tech area where you find NVDA, JNPR, ORCL, etc.etc.Very acceptable P:E s, balance sheet, proven need,and on.

    But memories are deep in tech land and any sign of a broad weakness will set-up a not so orderly fire drill.

    Your rec is solid common sense and well written

    but there must be a boat load of troopers feeling

    and thinking "Hey........another shot at glory then

    after I go to cash I'll simply re-allocate to growth,

    quality,and reinvested dividends.



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