Many investors are worried about a stock market correction at a time when the S&P 500 and Nasdaq are at or near all-time highs, despite 6.7% unemployment and an additional 6.7 million Americans employed only part time for economic reasons. If the market crashes, trillions in equity value will be wiped out overnight, and the prospect of losing even 10%-20% of your retirement portfolio is certainly harrowing. However, investors also must account for the possibility that the market will continue to rise for multiple years.
Overreacting, behaving emotionally, and being guided by fear are generally recipes for disaster for investors. The best long-term outcomes are achieved by adhering to established portfolio allocation principles and sticking with them, even through difficult periods. Slight adjustments can be made based on changing conditions, but it's bad practice to move too far from the plan. Consider these three ways to be responsibly prepared for a potential market crash.
1. Have cash reserves
Money in the bank is liquid and available, but people often hate the thought of sacrificing the growth that those assets could produce as investments. Investors should make sure that they have enough cash available and shielded from volatility to cover expenses, but not so much that they are missing out on growth opportunities.
Financial planners generally recommend having cash reserves of anywhere from three months' worth of expenses to six months' worth of income. The exact amount is up to you, but that's a reasonable range, depending on your household needs. For working people, a stock market crash often coincides with higher unemployment or tough times for small businesses, either of which could take several months to overcome for most households. For retirees, it can be disastrous to withdraw assets from an investment account that's fallen. If your cash reserves are too low, it's wise to move some assets out of capital markets and into an accessible bank account that's not volatile.
2. Make sure your investment allocation reflects risk tolerance
Investment allocation should always be aligned with risk tolerance, but this is especially important when the market is likely to move downward. Risk tolerance questionnaires are useful tools for determining how much of your portfolio should be in stocks versus bonds, based on how you'll perceive losses and gains.
Time horizon is a related determinant of allocation. Investors who have short-term and medium-term cash needs, such as retirees, can't afford to withstand a market downturn before withdrawing funds. Investors with long time horizons, such as young people investing for retirement, can easily overcome temporary bear markets that will be wiped out by future growth. If you are approaching or in retirement, you should have at least 30% of your portfolio in bonds, and potentially much more.
If a market crash is on the horizon, now is a great time to ensure that your allocation reflects your risk profile. Don't be overexposed to equities, but don't completely abandon them either.
3. Rebalance if necessary
Rebalancing might be necessary at the tail end of a bull market. High-growth stocks have outperformed other asset classes, and they've likely grown to make up a larger percentage of your portfolio than when the allocation was initially created. There's a reason that a balanced portfolio contains certain percentages of different kinds of stocks, and recent momentum doesn't nullify that reason.
The stocks that did the best work to drive growth in a bull market may be hard to sell, but many of them are also likely to drag an account down during a crash. Investors learned this lesson the hard way with internet stocks in the dot-com bubble and financial stocks in the global financial crisis. Investors shouldn't abandon high-growth stocks that have been performing well, but it's wise to take some gains and redeploy to other stocks that have less future success assumed in their pricing. If the market is going to crash, high-flying cyclical stocks are more likely to get crushed than stable and unremarkable ones. Investors should maintain a balanced allocation across sectors, industries, geographies, and company sizes.