If there's a stock market correction coming, you might be tempted to turn your stocks into a nice pool of cash. That might be fine for people who can magically see the future and time the market. The rest of us should follow some time-tested portfolio allocation rules and set ourselves up for long-term success.
Yes -- but it depends
Yes, you probably should be investing in the stock market right now. However, there are always some exceptional circumstances that call for a different set of rules. If you're one of those people who shouldn't be investing in stocks, then it's because of your personal financial plan, not the current state of the market.
Some people's financial situations are incompatible with volatility. Others need to adjust their stock holdings to align with their personal risk tolerance. For the most part, though, investors should have significant stock market exposure.
Image source: Getty Images.
Market cycles are unavoidable
If you're thinking about selling your stocks right now, you're probably actually fearing volatility -- and that concern is justifiable. However, it's absolutely not a good idea to panic or let fear dictate your next investment decision. Instead, we have to understand how volatility works and prepare ourselves for its consequences.
The stock market goes through cycles. It's natural to worry about losing money, but bear markets are just something you have to deal with. The minute you invested in stocks, you signed up for both good and bad times. There's no strategy that's immune to periodic downturns.
Consider the S&P 500 over the past 30 years.
Two things are very clear in this chart:
- Markets drop from time to time.
- The long-term trend is upward.
There were three serious crashes over the past 20 years, along with a handful of less severe corrections. They tend to follow extended periods of strong performance. Market cycles often last five to 10 years. These booms and busts are just temporary departures from the prevailing line of 7-10% average annual growth. That's the perspective you need to have if you want to invest successfully for the long term. When it seems too good to be true, it probably is. If it seems like the sky is falling, you're probably overreacting to short-term conditions.
Where we stand today
Stocks aren't cheap right now. The S&P 500 is expensive relative to profits, based on the P/E ratio and related metrics such as the cyclically adjusted P/E (CAPE). Dividend yields are also at historic lows for the market in total, including many high-profile dividend stocks, due to low interest rates. Basically, it's expensive to "buy" the profits and dividends that are produced by stocks.
SPY Dividend Yield and S&P 500 Shiller CAPE ratio data by YCharts.
We're in a more rational spot than the dot-com bubble, but there's clearly a heightened risk of a correction. We can acknowledge this fact without panicking, and it's not enough to justify drastic portfolio adjustments. Instead, we need to coexist peacefully with volatility because it's not always a bad thing.
Who should reduce their stock allocation
The next market crash could be around the corner, but it could easily take years to happen. We don't know, and there are complex forces at work. If we accept that bear markets are temporary and could happen at any time, then the question really turns into how to handle them.
How would it impact you if the market dropped 30% next year and recovered over the next decade? That's a drop in the bucket for retirement investors who will invest for the next few decades. Avoiding a dip isn't worth missing on potential growth. Not only should growth investors maintain their stock positions, but they also should continue buying more with new savings.
On the other hand, if you're retiring in three years and need access to cash, that's a different story. If you have a short time horizon or low risk tolerance, you need to make sure that your investment plan is properly balanced. Investors who are over-exposed to volatile investments should stop buying more stocks for a moment and rebalance their portfolios. Even in these cases, stocks should still make up a significant portion of your holdings.
Who should avoid the market entirely
So who shouldn't be investing in the stock market? People who have glaring holes in their financial plan should cover those first.
People with high-interest debt, such as large outstanding credit card balances, should probably pay that down before getting into the stock market. You probably won't achieve 20% annual returns in the market, so credit card interest is taking more money out of your plan than your stocks are adding.
People also must cover short-term cash needs before focusing on stocks. If you have to pay some bills in a few months, don't risk that money for small, short-term gains. Maintain a cash buffer for financial emergencies. When the unexpected eventually occurs -- and it will occur at some point over the years -- you don't want to be forced into selling stocks as a solution. That's a great way to ruin stock market performance or fall into a downward spiral with unhealthy debt.
Get your ducks in a row before you invest. Then you can fully embrace the market responsibly.
