After two months of euphoria, investors finally got some cold water thrown on their faces on Monday. And while one day is worthless in trying to figure out whether there's been a true change in the market's direction over the coming weeks and months, yesterday's 156-point drop in the Dow serves as a good reminder that you could easily see every penny you've made since March disappear even more quickly.
Obviously, the best way to prepare for a market drop depends on exactly what your investing strategy is. If you're already retired, for example, you're probably looking for ways to cut your risk -- even if it means passing up the chance for longer-term gains. On the other hand, if you have decades to go before you even start thinking about retiring, then you can look at a market drop as an opportunity, rather than a punishment.
So if you're a long-term investor, keep these thoughts in mind as you position your portfolio for what's coming.
Think small
In anticipation of a bear market, many investors instinctively gravitate to the largest companies in the economy. While businesses are struggling all over the globe, investors in behemoth stocks like ExxonMobil (NYSE:XOM) at least don't have to worry about seeing their shares go to zero anytime soon.
But before you throw everything you own into large-cap stocks, remember a couple of things. First, even huge companies aren't immune from financial disasters. Investors in companies such as General Electric (NYSE:GE) and Starbucks (NASDAQ:SBUX) can attest to the huge impact that the struggling economy had on their business models -- and on their shares' value.
Meanwhile, over the long haul, smaller companies have on average dramatically outperformed large-cap stocks. Advantages of just a few percentage points have made million-dollar differences for investors over the decades -- and now's no different. If you've been too scared of a market drop to include small-cap stocks in your portfolio, now's a great time to think about changing that.
Watch out for too much optimism
To invest in stocks, you have to be something of an optimist. You have to believe that the companies in which you invest will succeed and prosper in the future, and that their share prices will reflect those positive results and reward you.
Keep in mind, though, that Wall Street analysts -- especially those working for sell-side firms that try to sell shares to clients -- often paint a too-rosy picture of a stock's prospects. In order to protect yourself against those overly optimistic views of the future, it's prudent to build in a margin of safety just in case things turn out worse than expected. That way, even if the overall market goes down, you'll have the confidence you need to stick with a good company even if its stock drops.
Get out of dividend traps
Perhaps the biggest shock to investors over the past two years has come from companies deciding to stop paying dividends. Amazing streaks of dividends have come to an end, including Dow Chemical's (NYSE:DOW) cutting its quarterly payment for the first time in 97 years, and Pfizer's (NYSE:PFE) breaking a 41-year streak of annual dividend boosts.
Those companies won't be the last to cut dividends, either. But that doesn't mean all dividend stocks are suspect. Companies that have relatively strong earnings compared to their dividend payouts, such as Wal-Mart (NYSE:WMT) and Johnson & Johnson (NYSE:JNJ), are in a better position to sustain payouts than more highly leveraged companies with earnings that aren't as strong. Those companies don't have the highest yields, but they're more likely to keep them for years to come.
If you take care of those three concerns, you should be ready for whatever happens to stocks. Whether the market starts falling again or keeps moving higher, a solid strategy that manages these risks effectively will work over the long haul to get your portfolio back on track.
For more on preparing your portfolio for the worst, read about:
- How you can grab 20% dividend yields.
- 5 stocks you should avoid right now.
- Why not buy stocks that will love you back?
