Preparing For a Market DownturnSubmitted by Financial Advantage Associates, Inc. on December 22nd, 2017
Preparing For a Market Downturn
Jeff McGrath, CFA® Registered representative Investment advisor representative Chief investment officer Securian Financial Services
A downturn in the market is unpredictable but history suggests it’s inevitable. How you prepare for a downturn, though, is what counts. Today, we are in market nirvana. Since the market bottom in the first quarter of 2009, stocks have enjoyed a steady climb. Of course, there have been hiccups along the way, but nothing that qualifies as a market correction.
Covering the basics
Today’s bull market is one of 10 recorded since 1926. The average length of each is 54 months with the current one lasting over 99 months, second only to the 113-month bull market that began in October 1990 (JP Morgan, 2017). So, once again, investing utopia! But are you prepared for the next correction? There are simple actions you can take with the help of your advisor today to help weather the inevitable downturn.
- Create diversified accounts*. A key consideration in helping you reach your financial goals is through diversification in a way that matches your risk tolerance. Combining assets that have different return drivers and zigging when others zag should help smooth out market shocks and hopefully create a better investing experience over the long term.
- Rebalance accounts. Without rebalancing, your accounts can dramatically change their risk profile and drift away from your original investment profile. By selling the best-performing and buying underperformers, investors keep accounts at suitable risk levels. Reduce exposure to assets that may reach stretched valuations, while purchasing those that are undervalued. That may feel unnatural, but it’s the right thing to do. Talk to your advisor if you are unsure about how this process works.
- Replenish short-term cash needs. One of the biggest errors an investor can make is selling assets during a correction. Make sure cash is available in your accounts to meet liabilities over the next one to three years to help avoid this mistake.
Addressing behavioral biases
While this is valuable advice, it’s also table stakes. It’s important that advisors go beyond offering standard investment advice to help their clients combat emotions that can be detrimental to the long-term performance of their portfolios. It’s important that your advisor educates you on behavioral biases that are sure to arise during a market downturn. It’s a good idea to have these conversations during bull markets NOT when the bear raises its ugly head. Here are a few behavioral biases to understand.
- Loss aversion bias: Bias in which people strongly prefer avoiding losses as opposed to achieving gains. Naturally, we’re more concerned about threats than opportunities. This shows up in investing too. Looking at market history shows that downturns are part of a normal business cycle. Continue to communicate with your advisor about inevitable volatility in the market.
- Recency bias: The tendency to think that trends and patterns observed in the past will continue in the future. It’s tempting to want to invest in asset classes that performed well recently but rarely is that the path to success. Understand the randomness of asset class returns and the need to be in investments before they peak –not after.
- Action bias: Faced with uncertainty or ambiguity, investors would often rather do something than nothing – even if it’s counterproductive. Standing pat feels like giving up. Numerous studies indicate that if investors miss a few of the market’s best days, it may mean significant underperformance in the index. For example, in JP Morgan’s Guide to Retirement, they examine the S&P 500 from January 1, 1997 to December 31, 2016 and data shows that missing the market’s best 20 days dropped annual returns from 7.68 percent to 1.57 percent. This shows that the impact of staying committed to the market is paramount to long-term investing (JPMorgan, 2017).
- Availability bias: Bias in which people estimate the probability of an outcome based on how easily the outcome comes to mind. One of the most common examples is Home Country Bias, which refers to the tendency to own companies you’re familiar with. In the United States, Home Country Bias means you’re limiting your opportunity to the most followed, and perhaps, most efficient names – think Apple. The world is a big place where good investment opportunities know no bounds. Expanding your ownership may help increase the probability of identifying value, and in turn lead to investment success.
Making educated decisions
Downturns happen at regular intervals and are necessary for healthy economies. Working with your advisor to understand strategies and biases that happen in a downturn, and having these conversations regularly, even in good times can help lessen the impact and protect your long-term goals.