After ending 2021 at nearly an all-time high, the S&P 500 experienced its worst month since March 2020 in January, as the index declined more than 5%. While we've seen some recovery since then, it's good practice to take stock of your entire financial plan -- as well as your emotional barometer -- to see if you're well-positioned to endure a potentially long period of lower stock market returns.
Here, we'll review four lessons to be learned from last month's stock market debacle.
1. You need an emergency fund
While some people believe that the concept of an emergency fund is outdated, the reality is that in the midst of a stock market correction, you'll almost certainly feel differently. Widely accepted financial planning advice dictates that you should maintain an emergency fund -- that is, liquid cash reserves -- that covers three to six months of living expenses, depending on your specific circumstances. While this isn't necessarily the "return-maximizing" option, it serves other critical purposes.
First, a fully funded emergency fund allows you to leave your stocks alone when they decline in value. Selling your stocks at their lows to fund immediate-term expenses is a recipe for stunting your portfolio's long-term growth. Doing this should be a last-resort option.
Second, an emergency fund prevents you from trading on emotion. If you're following the news when the market crashes, you'll likely see nothing but panic sellers and flashing red numbers -- enough to make anyone feel like they should act.
The reality is that an emergency fund acts as a buffer between your emotions and your actions and is likely going to make you feel much better about sticking to your long-term plan if stocks go south.
2. Bonds are not dead
While people are quick to cite paltry yields as a reason to stay away from bonds entirely, it's important again to remember that bonds serve the purpose of reducing portfolio volatility, not necessarily maximizing investment return.
A portfolio that whipsaws back and forth, like one comprised entirely of common stocks, is likely to cause an investor to constantly question their decisions, potentially tempting unnecessary trading. A more balanced portfolio with a healthy bond allocation, on the other hand, has the potential to earn a very strong return without nearly as much embedded risk.
A recommitment to at least a 10% or 20% bond allocation is the ultimate display of humility: We don't know what stock returns will be in the future, but if they're not as good as we expect, we at least have a part of our portfolio available to mitigate outsized volatility.
3. The stock market is a risky place
Any time the S&P 500 is up 20% or 30% in a year, investors tend to think the short-term future will be like the short-term past, and the stock market can be relied upon for inflated returns every year. The reality, unfortunately, doesn't match this sentiment.
The stock market is a risky place that tends to favor those who invest for the long term. Day traders and short-term speculators are notoriously bad at beating the market over the long haul. Past returns are not predictors of future performance. And finally, money that needs to be used in the next three to five years shouldn't be tied up in the stock market.
Market corrections can be a valuable time for investors to reevaluate their respective asset allocations based on their need, ability, and willingness to take risk. If you're taking more risk than you'd like and your portfolio dropped more than you could bear in January, take this as a signal to rebalance and move forward with confidence.
4. Crypto is not a safe haven
Crypto returns have attracted investors of all sizes, but it's apparent that Bitcoin, as well as other established cryptocurrencies, haven't exactly provided a ton of portfolio protection during volatile stock periods. Bitcoin is positively correlated with the S&P 500, which means the two tend to move in the same direction, though not exactly in lockstep.
It's important to realize that cryptocurrency -- a fascinating idea and groundbreaking concept -- is not a safe haven of any sort. It's a volatile, speculative digital currency that can move in either direction at a moment's notice. While I'm certainly not saying it can't play a role in certain portfolios, it should be viewed as a risk asset exposed to many of the same economic risks as stocks.
A time to reevaluate risk
When the stock market falls, it's a great time to really evaluate how you felt. Be honest with yourself: When the market is down 10% or 20%, are you comfortable with your asset allocation? What about down 40% or 50%?
It's simply good financial planning to be realistic about how much risk you're taking, and to be careful to not take on more risk than you can reasonably bear. A sound financial plan reflects this central consideration, and moving forward with a plan is always the best choice -- even with an uncertain future.