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4 Ways to Crash-Proof Your Index Fund Portfolio

By Sam Swenson, CFA, CPA - Updated May 14, 2021 at 12:46PM

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Volatile markets can make one wonder how to reduce the emotional response.

Index funds provide a great way to get started with investing. As you'll quickly learn, a portfolio that's 100% in stock index funds will also come with a great deal of risk. When the market turns south, you might wish that you had at least a portion of your assets in lower-risk investments. Here, we'll look at some of the things you can do to reduce the emotional response you might feel if the market tanks. 

1. Maintain a solid cash reserve

You can term this an "emergency fund," but it serves multiple purposes. First, the goal here is not to earn a maximum return. The goal of your cash reserves is to provide security and liquidity in the event of market turmoil. 

When the market falls, the natural response is to want to sell your losing investments to avoid any further harm. If you have a share of your portfolio in cash, you don't need to worry as much about changes in your portfolio value, and the desire to sell long-term investments is muted. You're covered no matter what happens.

For this reason, a 5% to 10% allocation to cash can be comforting and useful -- and in the worst case, available during an emergency. 

Man with sword and shield defending market crash.

Image Source: Getty Images.

2. Diversify across regions

Even the most staunchly minimalist investors can see the argument for global diversification. This means allocating money to regions outside the United States, most commonly Europe and Asia. You can buy index funds that cover specific countries, continents, or even the entire globe. 

Note that international funds are a bit more expensive and come with currency risk, but the investment benefit when paired with domestic funds is usually worthwhile. A globally diversified portfolio, free of home bias, can reduce the overall volatility of your portfolio and give you the best chance for long-term success. 

3. Don't throw away bonds

One of the core pillars of successful financial planning is to stick to a written plan through the ups and downs of the market. Over the long run, portfolios that include some amount of bonds are likely to do nearly as well as 100% stock portfolios with far less risk. 

Some skeptics might say that the real return on bonds (the interest rate paid to bondholders less inflation) is negative right now in the long run. It's understandable why many might balk at holding bonds in the current interest rate environment. 

But remember: We only have historical returns and current prices to guide our decisions. We really don't know how bonds will perform in the future, or how interest rates might behave. But we can say with certainty that the stock market will fluctuate and that bonds are likely to be a safer source of stable income. 

For these reasons, it's best to consider bonds as a stabilizing and necessary position in your portfolio that serve an entirely different purpose than do stocks. Part of managing your money should include behavioral management, and bonds can help in keeping you honest. 

4. Automate where you can

When things are automated, they're more difficult to interrupt or change. This means that knowing your money will be invested continuously -- regardless of where the market happens to be trading at the moment -- can help prevent unnecessary action when market prices fluctuate. 

Automating also tends to change one's belief system around investing. What matters is that you invest at regular intervals, not that you invest at the cheapest price possible, which is impossible to know in advance. Simply committing to invest every week or two allows you to follow a pre-determined schedule and ignore market prices. 

You might have heard before that "time in the market beats timing the market," and it's good advice: Automated deposits to your investment account ensure that your money is always working for you, and can reduce the temptation to sell when markets are down. 

Find balance

With U.S. indexes broadly up through the beginning of this year (in addition to cryptocurrency surges and pandemic recovery), there's a tendency for people to be starry-eyed about the potential new heights of the market. These are exactly the moments that it's good to revisit some of the most basic investing principles and try to be prepared for whatever might happen next. Recent volatility has spurred the conversation: It's important to temper our desire for more money with wisdom and prudence.

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