No, I am not suggesting I have a crystal ball which allows me to predict the next stock market correction. However, we all know that a correction will come.
(As a reminder, a correction is defined as a decline of 10% of current market value.)
What we know is that, as the stock market begins to drop in value, it can be very tempting to “go to cash”. A recent study by Betterment who analyzed 58,000 IRA account holders from 2008 to 2012 found that those who went into cash had an average return of about 1 percent per year less than investors who stayed the course.
Here are our recommendations to prepare for a coming correction:
- Determine how much of a contingency fund you want to have on hand. In this way, when “you have a need to cover unexpected expenses”, you already have the cash in place. This helps prevent you from having to sell an asset while it is down in value.
- In addition to a contingency fund, for those of you who receive monthly income from your investment portfolio, it’s important to decide how many months or years of your income you want to have readily available. For example, you might decide to keep one year’s worth of income needs in cash at all times.
- Be sure your “revolving replacement fund” is also adequately funded. This is a fund that is used for predictable expenses such as the need to replace appliances and automobiles from time to. Again, it is important to determine how much money you want to have in this revolving replacement fund.Having adequate cash set aside or each of these possibilities helps allow you to stay invested during the correction.
- Now let’s talk about the money that is invested in the U.S. and/or international stock markets. First, we want to be sure that you are taking the amount of risk that is appropriate based on your age, health, time horizon and risk tolerance. It is very important that you understand the potential “drawdown” on your portfolio. The potential drawdown shows you how much your account could lose on paper during a correction. Again, you need to be sure that you are comfortable with the amount of drawdown exposure in your portfolio. This helps allow you to stay invested if/when the portfolio declines in value on paper.
As always, we would welcome the opportunity to answer any questions or discuss any concerns about your portfolio before the next correction.
Barbara A. Culver
CFP®, ChFC®, CLU, AEP®