When markets drop, most stocks go down with them, but investors can still make some savvy moves to protect some of their money in a downturn. Here are three things investors can do to help offset the risk of plummeting stock prices.
1. Rein in risk
The market has had an impressive run from its Great Recession lows, and that success may mean that more high-risk, speculative companies have crept into your portfolio. If that's the case, you're not alone. After all, bull market runs have a tendency to increase investor interest in emerging companies. For example, during the Internet bubble of 1997-2000, countless companies hit the market and soared to nose-bleed valuations despite the fact that they were lacking profits or even revenue. One of the most widely known of these companies was Pets.com, an online pet store that went public in early 2000 at $11, peaked at $14, and then shuttered its doors less than a year later.
If investors hope to avoid a similar fate, they should take an objective look at the companies in their portfolio to see whether or not revenue and earnings are growing and current valuations are justified. Personally, I like to see sales and earnings growth of 10% or more annually and a price-to-earnings multiple that is below 20.
You may not mind having some speculative names that don't pass this simple smell test in your portfolio, especially in high-growth industries like biotechnology. However, each of these companies should still be evaluated further to make sure your original investment thesis is still valid. If something fundamental has changed, it may be time to sell.
2. Store dry powder
In addition to going too far out on the risk curve, investors tend to get too fully invested during bull markets. Having all your money invested can boost your returns when stock prices are heading higher, but it can seriously limit your ability to buy great companies on sale during a market downturn.
That is particularly true when investors buy stock in margin accounts, which allow investors to use their current portfolio as collateral to borrow money to buy more stock. Margin accounts provide return-friendly leverage during the good times, but sliding stocks can quickly prompt brokers to demand that investors pay them back the borrowed money. Those margin calls can cut account values quickly and deeply, so investors looking to limit their downside during market dips should get off margin and park some money in cash. Having that buying power available may insulate returns in the downturn and allow you to buy industry-leading companies on sale when the market bottoms.
3. Slow your roll
It has been proven time and time again that investing for the long haul is the best way to build significant wealth. Remembering that investing is a marathon, not a sprint, comes in handy during manic markets, because it can keep investors from selling top-shelf, best-in-breed companies.
For example, there have been plenty of periods over the past decade when great long-term winners Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), and Netflix (NASDAQ:NFLX) have dropped sharply only to rebound to new highs. Those who sold those market leaders when share prices dropped likely regret it:
Instead of selling great companies when markets turn lower, a better strategy may be to focus your portfolio (and your investment watchlist) on those companies and then buy them once the market gets attractive again.
Cooler heads prevail
Reducing exposure to second-tier stocks, having cash handy, and taking the long view can help investors navigate market turbulence, but that doesn't mean investors won't see the value of their investments fall when the market takes a spill. The key thing to remember in any market decline is to be proactive, rather than reactive. After all, investors who plan ahead are likely to do better than those who fly by the seat of their pants.
Todd Campbell owns shares of Apple and Amazon.com. Todd owns E.B. Capital Markets, LLC. E.B. Capital's clients may or may not have positions in the companies mentioned. Todd owns Gundalow Advisors, LLC. Gundalow's clients do not have positions in the companies mentioned.The Motley Fool recommends Amazon.com, Apple, and Netflix. The Motley Fool owns shares of Amazon.com, Apple, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.