There's nothing scarier than a crashing stock market to make you second-guess whether you've done enough personal financial planning to make it through what could be tough times ahead. But by keeping a few simple tips in mind, you can ensure that no matter what happens in the markets in the days and weeks to come, you'll be comfortable that your financial plan will ultimately bring you success in reaching the goals you've set for yourself.
Theory vs. reality
It's all well and good during a bull market to think hypothetically about what you'd do if the stock market dropped dramatically. In fact, many investors explicitly wanted a correction like the one we've seen over the past month or so, hoping that a pullback would let them buy once-soaring stocks at somewhat cheaper prices.
Yet, when the correction actually comes, it can be a lot harder to follow through on the plans you made during calmer times. In the past two days, the Dow has fallen more than 550 points, with today's 354-point drop marking the worst day for the market since November 2011. Suddenly, the explanations for why stocks are dropping seem like they could continue to drag the market far lower, making stock purchases seem premature.
To keep yourself from making mistakes, consider these three tips to guide your personal financial planning:
1. Do a risk-tolerance gut check.
Financial planners use questionnaires to try to help their clients assess their tolerance for investment risk. But gauging your own actual reaction to corrections like the current pullback is far better than a questionnaire in helping you understand just how much you can tolerate volatility in your portfolio.
One big lesson that many people are learning now is that traditional methods of controlling risk won't necessarily work this time around. Bonds often provide protection against downturns, but lately, they've actually dropped more than the stock market.
Similarly, diversification within stocks didn't work well. The performance of iShares Russell 2000 (NYSEMKT:IWM) and SPDR S&P MidCap 400 (NYSEMKT:MDY) showed that there wasn't shelter available in small- and mid-cap stocks. International stocks often help protect against losses, but massive capital flight from emerging markets socked popular ETFs Vanguard Emerging Market (NYSEMKT:VWO) and iShares MSCI Emerging Markets (NYSEMKT:EEM) for single-day percentage losses that were nearly double the Dow's decline. Even developed markets suffered more than the U.S., as iShares MSCI EAFE (NYSEMKT:EFA) posted losses 50% greater than the U.S. market's.
If you're not comfortable with the risk profile of your investments, look back to why you picked them in the first place. If they're not doing the job you intended them to do, then looking for alternatives that will get the job done is best done sooner rather than later. On the other hand, if they are serving their intended purpose, then a temporary setback shouldn't make you deviate from your personal financial plan.
2. Make sure your cash needs are taken care of.
Many investors have avoided having much cash, since savings accounts and other cash investments pay next to nothing. But having cash on hand has two advantages. It gives you the opportunity to invest in beaten-down stocks while they're cheap, letting you take advantage of market crashes. Moreover, having cash already available means you won't have to sell assets later to cover living expenses and other cash needs, avoiding the trap that many investors fell into during the financial crisis when they had no choice but to sell their stocks at rock-bottom prices.
3. Remember that personal financial planning isn't all about investing.
When markets appear poised for a crash, it's easy to get hung up on the investing side of your financial plan. But a complete plan includes other important components, including insurance, tax management, savings, and spending. The best plans have enough flexibility to let you adapt to changing conditions in the investment markets by making minor modifications to spending and other areas that will raise your confidence level in getting through an extended period of financial challenges.
A big two-day decline can seem like it will inevitably turn out to be the beginning of a much larger crash, but you still shouldn't react emotionally to your losses. Rely on the personal financial planning that you've done, and take steps to be more comfortable with the protective aspects of your plan. That way, you'll recognize the potential for setbacks, and strengthen your resolve to stick with the goals that your past personal financial planning efforts have established so solidly in the past.
Fool contributor Dan Caplinger owns shares of iShares Russell 2000 and iShares MSCI EAFE ETFs. You can follow him on Twitter @DanCaplinger. The Motley Fool has no position in any of the stocks mentioned. 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.