Over the past few years, we've all seen a number of analysts, experts, and wealthy admired investors call for a market correction. Whether you believe the predictions are correct or not, you still have to wonder: What should you do to prepare yourself when a correction does come along?
When preparing your portfolio for a correction, you should first confirm that your initial investing thesis for each holding remains intact. Always have an investing thesis in mind when you buy, and keep it handy so you can review it when you're wondering how that thesis is holding up. Knowing why you purchased a stock and learning from both good and bad decisions you've made will not only help you make better chooses, but it will also increase your overall returns.
If any of your investing theses have fallen apart or played out, you then need to decide whether you should sell, or determine whether a new reason to continue holding shares has presented itself. Only during this review period is it wise to sell.
Next, determine whether your positions are still equally weighted or whether some have become too large of a percentage of your portfolio. If you own 10 stocks and each one represented 10% of your portfolio when you bought them, but now one stock has doubled while the others increased by 15%, you'll want to consider paring back the holding that doubled, bringing it back into alignment with the other stocks in terms of dollar value. Doing so ultimately lowers your risk, so that if that one stock bombs in the coming months, your total portfolio won't take such a massive hit. But before you make any selling decisions, you first need to decide what percentage is too large for any one holding to become.
Now that you've done a lot of selling, you can start buying. With the proceeds from your big winners and the stocks you no longer have a good investing thesis for, you can either purchase additional shares of current holdings, buy new stocks you've been watching, or hold the cash until the predicted correction hits and buy stocks at cheaper prices than they're currently selling for.
But as I hinted at, the pundits are constantly calling for a pullback -- and in some ways, they're always correct. My colleague Dan Caplinger recently commented that over the past 100 years, the market experiences on average a 5% correction three times per year, a 10% correction once annually, and a 20% correction once every three and a half years.
Based on these figures, you should review your positions once every four months to be safe. I'd also suggest checking in toward the end of earnings season, so that any information you decide to act on is current.
So what should you do if you knew the Dow Jones (DJINDICES:^DJI) and S&P 500 (SNPINDEX:^GSPC) was going to drop 5% or 10% tomorrow? Well, in one sense we all know a correction is coming. It's inevitable that the market will reverse course and head lower in the coming months or years. So if you're performing this kind of portfolio review regularly, then besides buying stocks with your extra cash after prices fall, the best thing to really do is ... do nothing. Don't panic. And by all means, don't sell. Sit back and relax, read the morning paper, sleep well at night, and know deep down that your money is safe and that the market will once again rebound and your assets will soon continue their appreciation journey.