Defending Yourself Against a Market Correction
The recent increase in the stock market is making a lot of investors nervous about the possibility of a significant correction. I am frequently asked what the market will do over the next few months. In reality, no one can predict market performance, especially in the short term. Your best defense against a volatile stock market is to create a financial plan and an asset allocation that is appropriate for your financial situation and time horizon.
If your current asset allocation is in line with your financial goals, there’s probably no need to make major adjustments to your current portfolio. Your asset allocation defines the percentage of different types of investments such as U.S. stock mutual funds, international funds, bond funds and CDs that are held in your portfolio. You should establish an asset allocation that corresponds with the timeframe of when your money will be needed. Investments in the stock market should be limited to money that isn’t needed for at least 5 to 10 years. Keep money that may be needed for emergencies and short term expenses in safe, fixed income investments like bank accounts, CDs or short term bond funds.
The stock market is inherently volatile and there will be years with negative returns. However, over long periods of time the market has trended upward with average annual returns on the S&P 500 exceeding 9% (approximately 7% when adjusted for inflation). It’s important to consider your emotional risk tolerance in establishing your asset allocation. You may have the time horizon to have a significant portion of your portfolio in stocks but you may not have the emotional tolerance. Your asset allocation may be too risky if you are tempted to sell whenever the market goes down or you are continually worried about your investments in the stock market.
Establishing an asset allocation that meets your situation can help your ride out fluctuations in the stock market more effectively than trying to anticipate movements in the market. It’s impossible to time the market and a short term increase is just as likely to occur as a drop in the market. Although you want to avoid timing the market, you should rebalance your portfolio on an annual basis to maintain your target asset allocation. Additionally, you will want to adjust your target allocation over time as your financial situation changes and you move through different phases of life.
Keeping other areas of your financial life in order can also help you through a major market adjustment. It’s essential to maintain an emergency fund of at least 3 to 6 months of expenses, make a habit of spending less than you earn, and save at least 10 -15% of your income.
Rather than focusing on where the market is headed and what the financial pundits are predicting, maintain an appropriate asset allocation and keep your financial affairs in order.